Valuing credit risk of a forward/swap

From CFA 2009 Morning, Question 9, They take: Current exchange rate discounted at foreign interest rate - forward exchange rate discounted at domestic From the CFA book, they do the same thing but dont really explain it. Can anyone shed some light on why one rate is discounted at CAD rate and one at yen rate?

Interest Rate Parity states: F/S = (1+R_d)^t/(1+R_f)^t When you rearrange the formula, you will get: F/(1+R_d)^t = S/(1+R_f)^t If F/(1+R_d)^t - S/(1+R_f)^t < 0, then the counterparty bears potential credit risk…

Perfect thanks

kurmanal, when you stated that if the equation is < 0, the counterparty bears the credit risk, you are assuming that the hedging party is short the foreign currency, which is not the case in the referenced question on the '09 exam. Please correct me if wrong, but if the hedger is long the foreign currency, < 0 would indicate that the hedger bears the credit risk

If the answer to the equation is (-) then it suggests the hedger is at a loss. If the hedger is at a loss (based on opportunity or otherwise) then his counterparty is at risk of him not fulfillign his obligation and paying…hence credit risk.

romyers2 Wrote: ------------------------------------------------------- > kurmanal, > > when you stated that if the equation is < 0, the > counterparty bears the credit risk, you are > assuming that the hedging party is short the > foreign currency, which is not the case in the > referenced question on the '09 exam. > > Please correct me if wrong, but if the hedger is > long the foreign currency, < 0 would indicate that > the hedger bears the credit risk You are right. In the question that was referenced, the formula should be reversed… Here, I was trying to explain where that “Current exchange rate discounted at foreign interest rate - forward exchange rate discounted at domestic” formula came from.

this reminds me the 09 exam AP Q9, i think the “LONG” action in the question was wrong, although you suppose to understand the foreign investing company would exchange foreign currency back to CAD but how about option credit risk? MOCK 10 Q17 says you should bear the risk as the WHOLE amount, but in 09 Q9, it does calculate the difference and a payoff as the risk amount. dont quite understand this

the credit risk is the MV of the option…in Q17, the MV of the option was given to you as $35, but in Q9 you had to calculate the MV of the option. Credit at risk is NOT the notional principal.

Value to long = Spot exchange rate discounted at foreign interest rate - Forward exchange rate discounted at domestic interest rate. Can you give a plain interpretation of this formula?

For one year currency forward, Value to Long = S(t)/(1+rFC) - F0/(1+rDC) = [S(t)\*(1+rDC)/(1+rFC) - F0]/(1+rDC) It seems the forward buyer is borrowing the foreign currency and investing in domestic currency?

This is a Level 2 question or can be derived from Level 1 formula. http://www.analystforum.com/phorums/read.php?12,1231639,1231639#msg-1231639 F(t,T)=S(t)*(1+rDC)/(1+rFC) — Level 1 formula. Value of long = [F(t,T)-F(0,T)]/(1+rDC) – Level 3, Credit Risk. :smiley: I mixed Forward price with Forward value. There are many other ways to do it, this one works for me. (T-t=1)

I find calculating the future spot price a bit more inuitive… is there a reason this is wrong? it gives a slightly different answer

I was looking at:

1.63 - 1.64*[(1.03^0.5) / (1.045^0.5)] = 0.001812879

Not to worry just got it… need to discount this back by the Rdc