MBA 2nd Semester (Finance major)

International Financial management (620181)

Chapter 5: Forward Exchange (Levi)

Question- 01: Define spot exchange rate & forward exchange rate.
Answer:

Spot exchange rate: The one- or two-day delivery period for spot foreign currency is so
short that when comparing spot rates with forward exchange rates we can usefully think of
spot rates as exchange rates for undelayed transactions. Spot exchange rate (or FX spot) is
the current rate of exchange between two currencies. It is the rate at which the currencies
can be exchanged immediately. According to the definition, delivery is theoretically
immediate; however, conventions of currency markets allow for up to two days for
settlement of a transaction.

The price of one currency expressed in terms of another currency at a given moment in time.

You can even use Google to find spot exchange rates. Just punch in a search query in the
Google search bar using the three-letter codes for currencies and it will get you the
exchange rate and even the final value of your money in the intended foreign currency. For
example, if you want to know the exchange rate between USD (United States Dollar) and
GBP (Great Britain Pound) in terms of USD/GBP, you simply write '1 GBP in USD'. Today,
18 June 2012, at 23:10 UTC, it gave me a value of 1.57 USD/GBP. It means it takes 1.57 USD
to buy 1 GBP.

Forward exchange rate: forward exchange rates involve an arrangement to delay the
exchange of currencies until some future date. A useful working definition is:

The forward exchange rate is the rate that is contracted today for the exchange of currencies
at a specified date in the future.
Forward exchange contracts are drawn up between banks and their clients or between two
banks. The market does not have a central location but instead is similar to the spot
market, being a decentralized arrangement of banks and currency brokers linked by
telephone, SWIFT, and clearing organizations.

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

Question-02: Define forward exchange premium & forward exchange
discount.
Answer:
Forward exchange premium: A forward premium is a situation in which the forward or
expected future price for a currency is greater than the spot price. It is an indication by the
market that the current domestic exchange rate is going to increase against the other
currency.

A Forward Premium or Forward Points Premium is the positive difference between the value
of a specific currency on the spot market and the exchange rate obtained through a forward
or a futures contract.
Forward premium is when the future exchange rate is predicted to be more than that of the
spot exchange rate. So if the notation of the Exchange Rate is given like Domestic/Foreign
and there is a forward premium, then it means that Domestic currency will depreciate.

Forward exchange discount: A forward discount is a term that denotes a condition in

which the forward or expected future price for a currency is less than the spot price. It is an
indication by the market that the current domestic exchange rate is going to decline against
another currency.

A forward discount is a situation whereby the domestic current spot exchange rate is
traded at a higher level than the current domestic future spot rates. The analysis of the
expectations from the market depends mostly on discounts and premiums. Also, they
enable one to know the currencies that should appreciate and those that will depreciate in
the near future.

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

Question- 03: Define forward rate and future spot rate. Differentiate between
them with explanation.
Answer:
Forward rate: A forward rate is the amount someone will agree today to pay for
something at a specified future time. The future spot rate is what someone will agree to pay
at that future time.
Future spot rate: The future spot rate is what someone will agree to pay at that future
time. For example, a month ago the forward price for a barrel of Brent Crude was about
$48. A Future spot rate is what the rate actually is in the future.

Differences with explanation:

If we assume that speculators are risk-neutral – that is, speculators do not care about risk –
and if we ignore transaction costs in exchanging currencies, then forward exchange rates
equal the market’s expected future spot rates. That is, if we write the market’s expected
spot price of currency j in terms of currency i as S*n (i/j) where * refers to “expected” and n
refers to the number of years ahead, then

For example, the market in general expected the euro to be trading at $1.3600/€ in one
year’s time, and the forward rate for one year were only $1.3500/€, speculators would buy
the euro forward for $1.35/€, and expect to make $0.0100 (= $1.3600 – $1.3500) on each
euro when the euros are sold at their expected price of $1.3600 each. In the course of
buying the euro forward, speculators would drive up the forward price of the euro until it
was no longer lower than the expected future spot rate. That is, forward buying would
continue until the forward price of the euro was no longer below the expected spot rate.
This can be written as:

Where inequality (3.3) means that the forward price of the dollar cannot be below the
expected spot price for the date of forward maturity: it must be greater than or at most
equal to. Similarly, if the market expected the euro to be trading at $1.3600/€ in one year’s
time and the forward rate for one year were $1.3700/€, speculators would sell euros

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

forward. They do this even though they have no euros and are not expecting any euros.
They would expect to profit from subsequently buying euros for delivery on the forward
contract at their expected price of $1.3600/€ which is $0.0100 less than the price at which
they have sold euros forward. In the course of selling euros forward speculators would
drive down the forward euro price until it were no longer above the expected spot price.
This can be written as:

Where inequality (3.4) means that the forward price of the euro cannot be above the
expected spot price for the date of forward maturity: it is either less than or equal to the
spot price. Inequalities (3.3) and (3.4) are consistent only if the equalities of both
relationships hold, that is

Question- 04: Discuss the payoff profiles on forward exchange.

Answer:
While the price paid for a forward currency equals the future spot rate expected by the
market at the time of purchase, when the forward contract matures its value is determined
by the realized spot rate at that time. The greater the extent to which the eventually
realized spot rate differs from the spot rate that was expected at the time of buying the
contract, the larger is the change in the value of the forward contract visà-vis the purchase
price. Stated differently, the larger the unexpected change in the spot exchange rate, the
greater is the change in the value of a forward contract between purchase and maturity. If
the spot rate is as was expected, there is no gain or loss on the forward contract. However,
if the spot rate is higher or lower than expected, there is a gain or loss. It is possible to plot
the gain or loss on a forward contract against the unanticipated change in the spot rate,
where the unexpected change in the spot rate is the difference between the anticipated
spot rate that influenced the forward rate and the eventually realized spot rate. Such a plot
is called a payoff profile, and is useful for comparing the consequences of buying different
instruments – forwards versus futures versus options – and for the management of foreign
exchange risk which we discuss in later chapters.

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

Let us develop a payoff profile by considering an example. Suppose that the expected spot
rate between the dollar and euro for one year’s time is $1.35/€ at the time of buying a one-
year forward contract to purchase €1 million with US dollars. With the forward rate equal
to the expected future spot rate, the forward contract will be priced at $1.35 million: the
contract buyer is to pay $1.35 million in one year’s time in exchange for €1 million received
at that time. Let us now consider the gain or loss on the forward contract when the
eventually realized spot rate is different from the originally expected rate.

As Table 3.3 shows, if the realized future dollar value of the euro is $1.34/€ instead of the
originally expected $1.35/€, the unanticipated decline in the euro by $0.01/€ causes a
decline in the value of the contracted €1million by ($0.01/€) × €1million, or $10,000. (Note
the € signs cancel in the multiplication to give a dollar amount.) On the other hand, if the
eventually realized US dollar value of the euro is $1.36/€, the dollar value of the contracted
€1 million increases by ($0.01/€) × €1million, or $10,000. Similarly, at a realized spot rate
of $1.37/€ the value of the €1million to be received under the forward contract provides a
gain of $20,000 ($0.02/€ × €1million).

Figure: 3.1

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

We plot the unanticipated change in the spot rate along the horizontal axis of Figure 3.1,
and the gain or loss on the forward contract to purchase €1million at $1.35/€ on the
vertical axis. The unanticipated change in the expected spot rate is written symbolically as
∆Su ($/€) where ∆ is “difference” and the “u” represents “unanticipated.”The gain (+) or
loss (–) on the contract is written as ∆V($), where the dollar sign indicates it is a US dollar
gain or loss. We see from the figure that the payoff profile is an upward-sloping straight
line. To the right of the vertical axis where ∆Su ($/€) is positive – that is, the euro has
unexpectedly gone up in value, or appreciated – there is a gain on the forward contract to
buy euros. To the left of the vertical axis where ∆Su ($/€) is negative – that is, the euro has
unexpectedly declined, or depreciated – there is a loss on the forward contract to buy
euros. A forward contract to sell €1million at $1.35/€ has a payoff profile that is opposite
to that in Figure 3.1.In order to construct the profile, we again plot the gains or losses on
the contract against the unanticipated change in the spot exchange rate.

These gains and losses, and the associated unexpected changes in the spot exchange rate,
are shown in Table 3.4. For example, selling €1 million for the contracted $1.35 million
when the realized exchange rate at maturity is $1.34/€ means having a gain of $10,000: the
forward contract provides $1.35 million for €1million at the contract rate, whereas
€1million would provide only $1.34 million if sold at the realized spot exchange rate.

However, if, for example, the realized spot rate became $1.36/€ the forward sale of
€1million at $1.35/€ means having a loss of $10,000: at $1.36/€ the €1 million is worth
$1.36 million versus the $1.35 million for which the euros were sold. When these and the
other values in Table 3.4 are plotted as they are in Figure 3.2 we obtain a downward-

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

sloping profile. The payoff profiles are useful for comparing the consequences of different
foreign exchange management techniques. Before we turn in the next chapter to the
profiles from other instruments, specifically futures and options, let us consider a few other
aspects of the forward exchange market.

Question- 05: Discuss the concept of outright forward exchange and swaps.
Answer:
Outright and swap transactions As Table 3.1 shows, the largest part of average daily
turnover on the foreign exchange market takes the form of swaps. The balance consists of
outright forward contracts. As the name suggests, an outright forward exchange contract
consists simply of an agreement to exchange currencies at an agreed price at a future date.
For example, an agreement to buy Canadian dollars in six months at Can$1.0511/$ is an
outright forward exchange contract.

A swap, on the other hand, has two components, usually a spot transaction plus a forward
transaction in the reverse direction, although a swap could involve two forward
transactions in opposite directions. For example, a swap-in Canadian consists of an
agreement to buy Canadian dollars spot, and also an agreement to sell Canadian dollars
forward. A swap-out Canadian consists of an agreement to sell Canadian dollars spot and to
buy Canadian dollars forward. An example of a swap involving two forward transactions

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

would be a contract to buy Canadian dollars for one month forward and sell Canadian
dollars for two months forward. This is a forward-forward swap. When the purchase and
sale are separated by only one day the swap is called a rollover. A definition of swaps that
covers all these forms is:
A foreign exchange swap is an agreement to buy and sell foreign exchange at pre-specified
exchange rates, where the buying and selling are separated in time.

Question- 06: Explain the forward quotations from the view point of outright
forward and SWAP.
Answer:
Swap points and outright forwards Even though some forward contracts are outright, the
convention in the interbank market is to quote all forward rates in terms of the spot rate
and the number of swap points for the forward maturity in question. For example, the 180-
day forward Canadian rate would conventionally be quoted as:

The quote on the spot is the way spot transactions themselves are quoted, and is in
Canadian dollars per US dollar. The spot rate means that the bid on US dollars is
Can$1.0265 – the quoting bank is willing to pay Can$1.0265 per US dollar – and the ask on
US dollars is Can$1.0270 – the quoting bank will sell US dollars for Can$1.0270 per US
dollar. The swap points, 23–27 in this example, must be added to or subtracted from the
spot bid and ask rates. Whether there is a need to add or to subtract depends on whether
the two numbers in the swap points are ascending (the second being higher than the first)
or descending. Let us consider our example. When the swap points are ascending, as they
are in the example, the swap points are added to the spot rates so that the implied bid on
US dollars for six months ahead is

That is, the quotation “Spot 1.0265–70; six-month swap 23–27” means the quoting bank is
bidding Can$1.0288 on the US dollar for six months forward. In other words, the quoting
bank is willing to buy six-month forward US dollars – sell Canadian – at Can$1.0288 per US
dollar. This is the six-month outright forward rate. Similarly, the above quote, “Spot
1.0265–70; six-month swap 23–27” is an implied outright ask on US dollars for six months
of

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur
While the rule for adding or subtracting points depending on whether they are ascending
or descending is the same whether rates are quoted in currency per US dollar – European
terms – or as US dollar per unit of foreign currency – US dollar equivalent – the
interpretation of whether the foreign currency is at a forward premium or discount is
different. In the case of the foreign currency per US dollar quotation used for currencies
other than the euro and pound, adding points means that the foreign currency is at a
forward discount; there is more foreign currency per US dollar for forward than for spot
delivery. This means that with quotation as foreign currency per US dollar, an ascending
order of swap points means the foreign currency is at a forward discount, and a descending
order means the foreign currency is at a forward premium. This is the opposite to the
situation with US dollar equivalent quotation with the euro and pound. Clearly, it is
necessary for foreign currency traders to think quickly and accurately.

Question- 07: State the Bid–ask spreads and forward maturity.

Answer:
The check that we have suggested, of seeing whether implied outright rates have wider
spreads with increasing forward maturities, is based on spreads observed in the market.
The reason banks quote larger spreads on longer-maturity contracts is not, as some people
seem to think, that longer-maturity contracts are riskier to the banks because there is a
longer period to maturity during which time spot exchange rates might change. As we have
explained, banks tend to balance their forward positions by the use of swaps and rollovers,
and since they can buy and sell forward for each maturity, they can avoid losses from
changes in exchange rates on forward contracts; whatever a bank gains (loses) on a
forward contracts to sell it loses (gains) on an offsetting forward contract to buy. Rather,
the reason spreads increase with maturity is the increasing thinness of the forward market
as maturity increases.

By “increasing thinness” we mean a smaller trading volume of longer-maturity forwards,

which in turn means greater difficulty offsetting positions in the interbank forward market
after taking orders to buy or sell. Remember that in the interbank market, banks state their
market and are then obligated if their bid or ask is accepted. The market-makers cannot
count on receiving offsetting bids and asks and simply enjoying their spreads. Rather, they

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur

may need to enter the market themselves to help offset a position they have just taken by
quoting their market. The longer the forward contract maturity, the less likely are
unsolicited offsetting orders, and therefore the more likely the market-maker is to face
other market makers’ spreads.7The difficulty of offsetting longer maturity forward
contracts makes them riskier than shorter-maturity contracts, but the extra risk involves
uncertainty about the price of an offsetting forward contract when reentering the market,
rather than uncertainty about the path of the spot exchange rate during the maturity of the
forward contract. That is, the concern is for uncertainty between rates when buying and
selling offsetting contracts, not uncertainty during the life of the contracts.

Question- 08: Discuss the Maturity dates and value dates.

Answer:
Contracts traded on the interbank forward market are mostly for even dates:“one
month,”“six months,” and so on. The value date of an even-dated contract such as, for
example, a one-month forward, is the same day in the next month as the value date for a
currently agreed spot transaction. For example, if a forward contract is written on Monday,
September 10, a day for which spot transactions are for value on Wednesday, September
12, the value date for a one month forward is October 12, the value date for a two-month
forward is November 12, and so on. A one-year forward contract agreed to on September
10 is for value on September 12 in the following year. However, if the maturity date is not a
business day, the value date is moved to the next business day.

For example, if a one-month forward contract is agreed on Tuesday, September 11, a day
for which spot value is September 13, the one-month forward value date would not be
Saturday, October 13, but rather the following business day, Monday, October 15.The
exception to this rule is that when the next business day means jumping to the following
month, the forward value date is moved to the preceding business day rather than the next
business day. In this way, a one-month forward always settles in the following month, a
two-month forward always settles two months later, and so on. It makes no difference
whether the terminology “one-month,” “two-months,” and so on is used, or whether the
terminology is “thirty days,”“sixty days,” and so on. The same rules for determining the
value dates for forward contracts apply whichever way we refer to even-dated contracts.

Hiramon Das, Lecturer, Dept. of Business Administration, MIST, Gazipur