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FORWARDS (Forward DISCOUNT (Determining Forward Rate (Spot rate - Forward…
FORWARDS
Forward DISCOUNT
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Currencies with higher interest rates = forward discount against currencies with lower interest rates. Forward price of currency will be lower than spot price
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BID/ASK
If forward points for descending (1.25 30/20), reference currency is trading at FORWARD DISCOUNT. Subtract forward points to obtain forward exchange rates
Forward PREMIUM
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Currencies with lower interest rate = Forward premium. Forward price of currency will be higher than spot price
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BID/ASK
If forward points are ascending (1.25 25/30), reference currency is trading at forward premium. ADD forward points to spot rate to obtain forward exchange rate
What is Forwards?
Definition
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If want fix a rate now but only receive/deliver in the future, need to buy/sell in forward market
Long/Short exposures
Long Exposure: receive foreign currency in the future. To hedge, sell foreign currency forward
Short exposure: pay in foreign currency. To hedge, buy the foreign currency forward
Examples
ABC company is based in SG, and is expected to receive USD100,000 in 3 months’ time, what is the company’ FX exposure?
Company ABC calls bank DBS for 3 month forward USD/SGD price. DBS quotes: 1.3800/10. What rate and how much will ABC sell USD100,000 for?
Interest Rate Parity
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The equilibrium relationship between spot and forward rate based on the relative interest rates of the two countries
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Carry Trade
Investor borrows money at a lower interest rate and invest in an asset that provides a higher interest rate to earn the interest differential
Taking long positions in currencies backed by high interest rates rely on relative stability in asset prices, as an adverse exchange rate movements can easily wipe out the returns from the underlying interest rate differential