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# K. Cuthbertson and D. Nitzsche - PowerPoint PPT Presentation

Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets) Figure 15.1 : Actual FX-forward contract :cash flows Quoted forward rate : F = 1.5(\$/£) Receive \$150 t = 0 t = 1 Time Pay out £100 Will receive \$150 and pay out £100 at t=1.

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### Figures for Chapter 15THE FOREIGN EXCHANGE MARKET(Investments : Spot and Derivatives Markets)

© K. Cuthbertson and D. Nitzsche

contract :cash flows

Quoted forward rate : F = 1.5(\$/£)

t = 0

t = 1

Time

Pay out £100

Will receive \$150 and pay out £100 at t=1.

No ‘own funds’ are used and no cash exchanges hands today (time t = 0)

© K. Cuthbertson and D. Nitzsche

contract

Using money market and the spot FX rate.

Data : r(UK) = 11%, r(US) = 10%, S = 1.513636(\$/\$)

Create cash flows equivalent to actual forward contract

begin by ‘creating’ the cash outflow of £100 at t = 1.

(2) Borrow £90.09

at r(UK) = 11%

t = 0

t = 1

Time

(3) Lend £90.09 x S

= \$136.36 in the US

at r(US) = 10%

(1) Pay out £100

Note : S = 1.513636 (\$/£) and no ‘own funds’ are used.

© K. Cuthbertson and D. Nitzsche

forward deal

Step 1 : Bank H actual FX forward contract.

Actual forward contract (bid)

t = 0

t = 1

Time

Pay out euros

How much ?

Bank H will receive \$1 and pay out euros at t = 1

What rate should Bank H charge for buying the base currency, USD forward -

that is its BID RATE.

© K. Cuthbertson and D. Nitzsche

forward deal

Step 2 : Hedging the forward position using spot FX and money markets.

Create cash flows OPPOSITE to those in the F.C.

Begin by ‘creating’ the cash outflow of \$1.

= S(1+rEU,b)/(1+rUS,O)

(2) Borrow USD = \$1/(1+rUS,O)

t = 0

t = 1

Time

(3) Sell these USDs for euros at spot rate (euro per USD).

Hence at t = 0 lend EUROs = S/(1+rUS,O) at the bid rate rEU,b

(1) \$1

© K. Cuthbertson and D. Nitzsche

for forward deal

Step 1 : Bank H actual FX forward contract.

How much ?

Actual forward contract (offer)

t = 0

t = 1

Time

Pay out \$1

© K. Cuthbertson and D. Nitzsche

for forward deal

Step 2 : Hedging the forward position using spot FX and money markets.

Create cash flows OPPOSITE to those in the F.C.

Begin by ‘creating’ the cash outflow of \$1.

(1) \$1

(2) Borrow USD = \$1/(1+rUS,O)

t = 0

t = 1

Time

(2) Lend \$1/(1+rUS,b)

(4) will pay out = S(1+rEU,O)/(1+rUS,b)

= F(offer) = 1.00553

To lend USDs at t = 0 we have to first borrow euros

and switch them into spot dollars

© K. Cuthbertson and D. Nitzsche

with an FX swap

Bank H : Cash flows (F = 0.625 £/\$, S = 0.65 £/\$, F-S = -250, hence rUK < rUS)

A. The Outright forward contract

F = 0.625 (£/\$)

Pay out £6.5m

B. Spot transaction (S = 0.65(£/\$))

t = 0

Sell \$10m (pay out)

C. The FX swap (swap points = -250)

Swap points = -250

t = 1

t = 0

Sell £6.5m (pay out)

Sell \$10m (pay out)

© K. Cuthbertson and D. Nitzsche

exchange rate

Price ratio (\$/£) - PPP exchange rate

S(\$/£)

Actual exchange rate (\$/£)

© K. Cuthbertson and D. Nitzsche