The Forward Market and the Forward Exchange Rate. Understanding the use of the forward market and what determines the “equilibrium” forward exchange rate. Foreign Exchange Rate Quotes. Recall that exchange rates can be quoted for two possible settlement dates:
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Understanding the use of the forward market and what determines the “equilibrium” forward exchange rate
GBP/USD (i.e., American Terms): GBP Selling at a Forward Discount Against the USD
USD/GBP (i.e., European Terms): USD Selling at a Forward Premium Against the GBP
USD/JPY (i.e., European Terms): USD Selling at a Forward Discount Against the JPY
JPY/USD (i.e., American Terms): JPY Selling at a Forward Premium Against the USD
U.S. Firm Paying GBP in 6 Months
U.S. firm Receiving GBP in 6 Months
U.S. firm has a GBP receivable which will be paid in 6 months.
Problem with an “uncovered” position:
If the GBP weakens in 6 months, the U.S. firm will receive less USD.
U.S. company “locks” in the USD return of the GBP receivable by selling GBP 6 months forward at the forward rate quoted.
$1.5812 in the previous example
The U.S. firm has “covered” (i.e., hedged) its GBP 6 month receivable.
F.X. Rate Pip Difference Interest Rate
Calculating the forward rate for periods less than and greater than one year
USD/JPY spot = 82.00
6 month JYP LIBOR = 0.12%*
6 month USD LIBOR = 0.17%*
*Annualized interest rates
Ftet = 82.00 x [(1 + ((0.0012 x 180/360))/((1 + ((0.0017 x 180/360))]
FTet = 82.00 x (1.0006/1.00085)
FTet = 82.00 x .9997
GBP/USD spot = 1.5800
5 year GBP interest rate = 1.05%*
5 year USD interest rate = 1.07%*
*Annualized interest rates on Government securities.
Calculate the 5 year forward pound:
FTat = Soat x ((1 + IRus)n/(1 + IRf)n)
n = number of years
FTat = 1.5800 x ((1 + 0.0107)5/(1 + 0.0105)5)
FTat = 1.5800 x (1.05466/1.05361)
FTat = 1.5800 x 1.001
FTat = 1.5816 (Note: This is the forward 5 year rate)