Currency quotations HELP PLEASE!

CFA Level III Derivatives
#1

Hi everyone, currency futures/forwards are driving me nuts. I understand the concepts (mostly) but I get really confused by the way things are quoted.

For example. if the book (schweser p.156 of book4) says the spot exchange rate is $1.42 per British pound and the forward is $1.43.

If you go long this contract, what are you buying? Pounds or USD? I thought it was USD but the book says to hedge a pound exposure, a US investor should short this contract (as in to deliver the pounds and get dollars), which suggests the opposite.

Then the next example has a US investor that has to pay someone in euros. This time the rates are expressed in euros (0.8 euros per dollar) and it says they should buy the contract, ie buy euros so they can pay their bill. This example makes sense to me but it doesn’t seem to match the one above? Argh!

Any help appreciated, thank you.

#2

prices of forward contracts can get quoted either directly (domestic per foreign) or indirectly

step 1: determine your currency exposure (e.g. pound in the first example) – you have long position if it is an asset or short if liability

step 2: take opposite position to hedge (e.g. short the pound)

#3
  1. As an investor I care about where am I capturing my returns?

It could be in USD if I am justing investing OR be in PND if there are outstanding liabilities in PNDs.

  1. How should receive the quote; Always have curr of my returns in den for the quote to enable to see the movement.

Now applying these to the example in here,

The quote $1.42/PND in spot and 1.43/PND in forward. It is clear from this that PND is appreciating. So bring USD to den; you will find depreciating - so short the contract to take advantange if is better than IRP differential

Lets say, I have a PND liability, now, I like this quote, however I want to long it and use the quote to the extent of my liabilities. As I am able to pay more liabilities in non-USD currency.

HTH

#4

Currencies are confusing! But let me try to explain.

A simple way to remember quoting convention is you should always look for which currency is after the “Per”

In this case it is USD per GBP

This means we are comparing how manydollars it takes to purchase 1 pound, ($1.43)

So now lets say I am a US firm with retail outlets in england. this means I am constantly exposed to the pound as I collect sales receipts in gbp and then need to convert them to USD. In order to hedge this risk, I need to somehow short the pound (take a position to profit from the depreciation of the pound using futures). So, if gbp drops against the USD, I will lose on my expected sales receipts but I will gain on the futures contract. No matter how the currency pair is quoted, I know that I always need to somehow short the pound to neutralize this exposure.

Now, If I am looking at a futures contract quoted $1.43 per british pound (GBPUSD) or (USD/GBP), I know that I can either sell 1.43 USD and purchase 1 pound, or I can sell 1 pound and purchase 1.43 USD (ignoring bid-ask)

You can also think of it like this 1.43USD/1.00GBP, simply quoted as $1.43 USD/GBP

So what does the above exchange rate need to do for the gbp to depreciate?

Since currently it is 1.43USD/GBP, hence it takes 1.43 USD to buy 1 GBP, if the exchange rate falls to 1.30 USD/GBP for example, it will now cost me only 1.30 USD to buy the same 1 GBP, hence the GBP has depreciated. If I had shorted the 1.43 exchange rate I would have gained as the GBP depreciated agains the USD, which is exactly what I wanted to do.

If rather I had operations in england and sales in the US, I would be exposed to rising GBP as I need to pay employees etc in pounds. In this case I would take the opposite position as described above.

Hope this makes sense.

#5

Cathurj that is a great explanation, thank you.

I guess I don’t understand why the quoting is different in the second example?

it is quoted as 0.8euros per dollar and yet to buy euros you go long the contract…I would have thought this decision would have resulted in you selling euros…

Any more advice hugely appreciated!!

#6

excellent explanation by Cathurj !

Kiakaha ,

“it is quoted as 0.8euros per dollar and yet to buy euros you go long the contract….I would have thought this decision would have resulted in you selling euros….”

As Cathurj points out , you want to be long Euro , to offset your short euro position, since by paying salaries of employees you are going to be short Euros ( think of bringing bags of Euros in a truck to pay your employees , you are delivering Euros , so you are short Euro) .The forward long Euro contract immunizes you against the euro suddenly rising and increasing payments in dollars

The type of quote itself is not important 0.80 Euro per dollar could also be written as 1.2 Dollars per Euro. As a US investor or company owner you always think of receiving or paying dollars , so conveniently you can flip the quote to see your dolar rate for the euro , which you want a long exposure for.

#7

Great points janakisri,!

to add a few more thoughts to the second example above…

as I mentioned, you must always determine which currency is “base 1”

For 1.43 USD/GBP - GBP is “base 1” because it takes 1.43 US$ to buy 1 Pound

For 0.80 Euro per dollar - USD is “base 1” because it takes 0.80 Euro to buy 1 Dollar

Notice that these two exchange rates are inversely quoted …

You can also quote 0.80 Euro per dollar as Janakisri mentioned as

(1/0.80) USD per Euro or 1.25 USD per Euro. Notice that in both quotes - 1.25 USD per Euro and 1.43 USD per GBP, the foreign currency is “base 1”

These exchange rates now similarly quoted will behave the same way, where as the 0.80 Euro per dollar will behave in an opposite fashion as the foreign currency appreciates or depreciates against the dollar

Here is more detail for clarity…

as mentioned you can also quote 0.80 EUR/USD as 1.25 USD/EUR and if you need to take a long position in EUR, if you quote it one way, you will need to short the EXCHANGE RATE and the other you will need to long the EXCHANGE RATE in order to profit when EUR appreciates…

Lets say I am US firm with operations in germany… of course I am exposed to appreciating Euro against the dollar… therefore in order to hedge my risk, i need to GO LONG Eur in the futures market against the dollar, that way when I lose as Eur appreciates against dollars because I need to pay my european employees… I will gain as my Long EUR futures contract appreciates, neutralizing this exposure. Now that we know what position we need to take, we need to determine whether you should “buy or sell the EXCHANGE RATE” in order to be long the EUR. Notice that I did not say we need to determine whether you should buy or sell EUR, we already know we need to buy EUR. What I said was we need to figure out that given a certain quoting convention, whether we should buy or sell the EXCHANGE RATE in order to take a long position of EUR against dollars

Now this is how we determine this… If the quote in the futures market is 0.80 EUR/USD, or re-written 0.80 EUR / 1.00 USD, what needs to happen to the EXCHANGE RATE for EUR to appreciate against the dollar?

IF I want to buy $1, it will now cost me 0.80 EUR. What if the exchange rate moved to 0.70 EUR/USD? In order to buy the same $1, it will now cost my only 0.70 EUR! Hence Euros have appreciated. Therefore using this quoting convention… I need to take a short position in the exchange rate in order to profit when EUR appreciates against the dollar.

Now for the inverse example… If instead the quote in the futures market is 1.25 USD/EUR, or re-written 1.25 USD/1.00 EUR, what needs to happen to the EXCHANGE RATE for EUR to appreciate against the dollar?

IF I want to buy 1 EUR, it will cost me 1.25 USD. What if the exchange rate moved to 1.40 USD/EUR? In order to buy the same 1 EUR it will now cost my 1.40 USD! Hence Euros have appreciated. Therefore using this quoting convention… I need to take a long position in the EXCHANGE RATE in order to profit when EUR appreciates against the dollar.

You should now see that it is irrelvant which way currencies are quoted as long as you take either a long or short position in the exchange rate that will make you a profit when EUR appreciates.

hope this helps!

#8

carthurj great explanation. You have taken a lot of time and put in effort to explain. I was just browsing and saw your detailed explanation. Great job ! Janakisri - same to you too, great explanation.

#9

Howdy!

That’s not your fault: as with many other areas in finance, the language that practitioners use is incredibly sloppy.

In this problem, the company will be receiving British pounds, but they want US dollars, so in the futures contract they should take the position of delivering (being short) pounds and receiving (being long) dollars. You’re given the exchange rate quotes (spot and future) in units of $/£.

If you think of currencies as commodities, then you’ll understand the language they’re using. If, for example, you had a futures contract on wheat, the prices (spot and future) would be quoted as, say, $/bushel; the thing you’re long or short (wheat) is in the denominator of the quote.

So, when the quote is in $/£, your long/short position (in the contract) is your long/short position in pounds: the one in the denominator. That’s the language they’re using. the company wants to be short pounds (in the futures contract), so they take the short position in the contract.

In this example, they got their language wrong. The company needs euro to make their payment, so they want to be long euro and short dollars in the futures contract. But quotes are given as €/$, so dollars is the commodity, and they should take the short position in the futures contract.

You’re correct, it doesn’t match the earlier example. Such is the way of finance people.

My pleasure.

#10

I always find it much easier to understand commodity contracts than exchange rate contracts. So whenever I get confused in exchange rate forwards, I try to find out what the underlying “commodity” is for the transaction. That would be anything that the investor wants to buy or sell in the future.

In your first example, the underlying commodity is GBP, since the investor wants to sell GBP in the future. So GBP is like gold or oil and USD per GBP is like the price of gold or oil (the currency following ‘per’ will be the underlying commodity). Once this is ascertained, it becomes much easier to understand what position must be taken in the contract.

Hope this helps.

#11

Thanks to all for the excellent responses on this! Very kind of you to take the time.

#12

Great explanations guys! Much appreciated!