Welcome back.
In this lesson we learn the difference between the spot rate and forward rates and how to calculate
the forward premium or discount.
We shall also learn the arbitrage relationship between spot rates forward rates and interest rates we
end this lesson with a discussion on foreign exchange markets and the participants in the markets.
Let's get started.
A spot exchange rate is the currency exchange rate for immediate delivery which for most currencies
means the exchange of currencies takes place two days after the trade a forward exchange rate is a currency
exchange rate for an exchange to be done in the future which can be 30 days 60 days 90 days 180 days
or one year when a firm buys or longs a currency forward it is obliged to exchange a specific amount
of the base currency for a specific amount of price currency on a future date specified in the contract.
You may wonder how this would be useful.
Consider an Australian firm that will receive 10 million euros from a German firm 90 days from now.
If the Australian farmers uncertain that the euro will retain its value 90 days from now it can lock
in the current forward rate by entering into a forward agreement.
For example the forward covers 10 million euros at the 90 day forward rate of one point 5 5 9 7 a duty
per Euro this essentially means that the Australian firm has agreed to exchange the 10 million euros
90 days later or fifteen point five nine seven million a day with another counterparty a forward exchange
rate quote can be expressed as an absolute value which in this case is one point 5 5 9 7 or in terms
of the difference between the spot exchange rate and the forward exchange rate.
For example if the spot exchange rate for a deeper euro is one point 5 5 2 0 the 90 day forward exchange
rate can be expressed as spot plus 77 pips or points.
Remember one Pip is zero point zero zero zero one or the fourth decimal place.
So if the 180 day rate is spot plus 121 pips the absolute 180 day forward rate is therefore one point
five six four one
when the forward rate is higher than the spot rate.
We say there is a forward premium since one euro can buy more.
A few deals in the future.
We expect the euro to appreciate against a U D and A U D to depreciate against the euro Conversely when
the forward rate is lower than the spot rate we say there is a forward discount since one euro buys
less a new deal in the future.
We expect the euro to depreciate against a new day and a few days to appreciate against the euro calculate
in the forward discount or forward premium is very straightforward.
It is basically the percentage difference between the forward rate and the spot rate.
Using this formula so in this case the 90 day forward premium of the EU D per euro rate is therefore
zero point 4 9 6 percent since we have the forward rate for three months.
We could annualize the discount simply by multiplying by 4.
Now one important question that we haven't addressed is what determines the forward premiums or discounts
to answer this.
We need to understand the arbitrage relationship between the spot rate forward rate and the interest
rates in the two countries let's say the one year interest rate for risk free government debt is 5 percent
in Australia and 3 percent in the eurozone.
Assuming that the spot and one year forward rates are the same at one point forty five to an arbitrary
sure can earn riskless profits by taking the following steps Firstly he borrows 1000 euros for one year
at the risk free rate of 3 percent and uses it to purchase a D at the spot rate he invests the A.D.
the risk free rate of 5 percent for a year and at the same time he enters into a currency forward to
sell a UTI at the forward rate of one point by five to after one year he would have one thousand six
hundred twenty nine point six a U D including interest as he has the forward contract.
He can sell the HD at one point five five two rate which means he exchanges all the EU deals for 1050
euros.
He repays his loan with interest and he pockets 20 euros totally risk free with zero cash outlay if
you've gone through the derivatives course you would have learnt that such arbitrage opportunities cannot
persist.
Arbitrage years will pursue this opportunity which is to sell euro to buy a new day which decreases
the HD per Euro spot rate and selling the HD forward which increases the forward exchange rate vs continues
until the Forward Rate is at a no arbitrage level against the spot rate.
So here we see that when the Forward Rate is increased to one point 5 8 to 1 the net cash flow at the
end of the year to the arbitrage year is zero this level where there is no more arbitrage opportunity
is the equilibrium level for the forward exchange rate the low arbitrage relationship between the forward
rate swap rate and interest rates is as such.
If we plug in all the figures into this relationship the equation balances meaning there is no arbitrage
opportunity and the rates are priced correctly let's have some practice the spot Japanese yen per US
dollar rate is one hundred ten point eighty six.
If the 180 day risk free rate is zero point two percent in Japan and one point eight percent in the
US what is the no arbitrage 180 day forward exchange rate for JPY per USD rate pause the video now and
work out your answer and we're back first.
I hope you did not make this mistake unless otherwise stated interest rates are quoted in annualized
figures.
So to get the 180 day interest rates we have to divide the annual rate by two plug in the figures and
we get a forward rate of 1 0 9 point 9 8 as the forward rate is at a discount.
We expect yen to appreciate and the US dollar to depreciate
and to conclude this lesson.
Let us learn the functions of foreign exchange markets and the types of participants we've learnt earlier
in our example of an Australian firm which is concerned about exchange rate risk for a foreign currency
payment that it expects in the future by entering into a forward currency contract to sell the 10 million
euros in the future.
The firm is effectively reducing or eliminating its foreign exchange risk with regards to this receipt
the counterparty could be another firm that wants exposure to currency risk instead of reducing its
currency risk the firm could be of the opinion that the euro will appreciate against the Australian
dollar.
So by locking in the rate for euro with the Australian firm it can stand to profit when the euro indeed
appreciates against the EU D when a firm takes a position in the foreign exchange market to reduce an
existing risk.
We say the firm is hedging its risk Alternatively when a transaction and the foreign exchange markets
increases currency risk.
We term it as speculation investors companies and financial institutions such as banks and investment
funds all regularly enter into speculative foreign currency transactions besides corporations.
There is a diverse range of market participants ranging in size from multi-billion dollar investment
funds down to individuals trading for their own account one Broadway to categorize them is to place
them in the sell side or buy side the sell side generally consists of large foreign exchange trading
banks such as Citigroup UBS and Deutsche Bank the buy side consist of clients who buy foreign exchange
products from the sell side banks such buyers can include corporations that frequently engage in cross-border
transactions so they need to purchase and sell foreign currencies.
As a result like in the example of the Australian firm most of such corporations enter into FCX forward
contracts to hedge the risk of future receipts and payments in foreign currencies real money accounts
refer to mutual funds pension funds insurance companies and other institutional accounts that are restricted
in their use of derivatives and leverage most managers of real money accounts hedge their currency risk
if they hold foreign securities leveraged accounts referred to the various types of investment firms
that do use derivatives including hedge funds high frequency algorithmic traders and the proprietary
trading desks at banks some of these accounts actively trading currencies to enhance returns the retail
market refers to affect transactions by households and relatively small institutions and may be for
tourism cross-border investment or speculative trading governments and government entities include the
government itself central banks and sovereign wealth funds governments acquire foreign currencies for
transactional needs central banks sometimes engage in FCX transactions to effect exchange rates in the
short term sovereign wealth funds use effects derivatives to both hedge currency risks and speculate
for higher returns and that concludes this lesson on forward exchange rates.
In our next lesson we shall learn the different types of exchange rate regimes in the world.
See you soon.