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Finance 476. Forwards. Forwards. a forward contract is a contract to exchange two currencies in the future, at a rate that is set now. forwards are typically contracts between a firm wishing to hedge exchange rate risk, and the firm’s bank. Example :

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Finance 476

Finance 476

Forwards


Forwards
Forwards

  • a forward contract is a contract to exchange two currencies

  • in the future, at a rate that is set now

  • forwards are typically contracts between a firm wishing to

  • hedge exchange rate risk, and the firm’s bank

Example:

Canadian firm is due to make a payment of $1,000,000 US to

an American supplier in 90 days. How many Canadian dollars

The payable will cost depends on the exchange rate in 90 days,

which is unknown. Therefore, the firm faces exchange rate risk.


  • Example continued:

    • Spot rate = 1.3343 $Can/$US

    • 90 day forward rate = 1.3397 $Can/$US

    • At today’s spot rate, the payable would cost $1,334,300 Can.

  • The firm could sign a 90 day forward contract with its bank.

    • the firm would be long $US in the contract

    • the bank would be short $US in the contract

  • In 90 days the bank gives the firm $1,000,000 US and

  • the firm gives the bank $1,339,700 Can.

    • Firm knows exactly what the payable will cost

      • - no risk


    Note:

    When a firm hedges with a forward, it is getting rid of

    possible downside risk, but also giving up potential for beneficial

    movement in exchange rate.

    Example:

    German firm is due to receive $1,000,000 US in 30 days.

    - spot rate = 1.1811 $US/€

    - 30 day forward rate = 1.1801 $US/€


    Amount of

    received by firm

    unhedged

    840,336

    Hedged with forward

    847,386

    854,701

    spot rate in 30 days

    1.17

    1.1801

    1.19


    What determines the forward rate
    What determines the forward rate?

    • forward rates are determined by interest rate differentials

    • between the two currencies

    • specifically, forward rates are determined by interest rate parity

    Where f1 is the forward rate for 1 period from now and e and f

    are in terms of units of domestic currency per unit of foreign

    currency.


    • which interest rates are used in interest rate parity?

      • Eurocurrency rates for the two currencies

    • Eurocurrency = currency held in bank account outside of the

    • country from which the currency originates

      • Examples:

      • $US in a bank account in London = euro-dollars

      • ¥ held in bank account in Cayman Islands = euro-yen

      • et cetera


    Note that eurocurrency rates are typically quoted as annualized

    based on a 360 day year.


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