# 2008 mock Q 7C (Forward) Red River

seems simple but i just dont get it: Red River shorts a 2-year forward currency contract on JPY denominated in ZAR at 15JPY/ZAR forward rate. the contract expires today exchange rate was 14.5JPY/ZAR when red river entered the contract the spot (current) rate is now 17.50 JPY/ZAR compound annual interest rates for the two year period: 1 % for JPY and 10 % in ZAR who bears the credit risk: is it Red River or its counterparty?

If expiration is today, then Red River bears credit risk: They have contractual price 15 JPY for ZAR, but spot rate now is 17.5 JPY for ZAR (so JPY decreased in value). Let’s assume, forward amount was 10 m JPY. So under the contract they would get 10 000 000/15 = 666 666.6 ZAR, But if contract is not in force they sell JPY for spot price 10 000 000/17.5 = 571 728.5 ZAR Credit risk amount for Red River is the difference = 95 238 ZAR It seems more interesting to evaluate credit risk amount in the day of entering the contract (2 years back from now): Forward rate = 14.5*1.01/1.10 = 13.31 (JPY should appreciate becouse of rates difference). Credit risk amount at contract expiration = 10 000 000/15 - 10 000 000/13.31 = -84 648 ZAR . Discounted the day entering the contract = -84 648/1.10 = -76 953 ZAR (bears counterparty, not Red River) Is it correct, guys? Have I not missed anything?

I say Red River because it is long Yen, so sold it forward to hedge against depreciation by locking in Zar.0667/yen and gets more ZAR under the contract since yen depreciated. F at t=2 is So[(1.1^2)/(1.01^2)] = Zar.0818/yen return on the fowrard should be (Ft-F0)/So => (.0818-.0667)/.069 = 22% risk is still bore by Red River as there is a gain.

remember San Francisco Fire Department (SF FD) S = 14.5 F = 15 F = 1% D= 10% 14.5/1.01^2 - 15/1.10^2 = 14.21 - 12.39 = 1.82 The contract has a positive value of 1.82 so Red River bears the credit risk since the premium is theirs to loose.

sebrock, not understanding why you discount current spot of 14.5 back two years. The rates given are two year rates of 1% for yen and 10% for SAR. Much thanks for the explanation.

isnt it a two year forward?

It’s the formula to figure out what has more value - taking the spot and investing it at the foreign rate for two years or taking your forward premium and investing it domestically for the same amount of time.

original post: Red River shorts a 2-year forward currency contract on JPY denominated in ZAR at 15JPY/ZAR forward rate. the contract expires today exchange rate was 14.5JPY/ZAR when red river entered the contract the spot (current) rate is now 17.50 JPY/ZAR compound annual interest rates for the two year period: 1 % for JPY and 10 % in ZAR ********************************************************************** I don’t know where this question is from, but from what was posted, it seems that it is a 2yr forward expiring tday. The spots given was from 2yrs ago (at contract initiation) and today (at contract expiration).

Can anyone please send me the mock exams? alugun@gmail.com thanks

this is a question from the 2008 cfai questions. u may take a second look at the subject heading for further details

but since F = So [(1+Rdc)/(1+Rfc)]^2 , it should it translate into: F(1+Rfc)^2 = S(1+Rdc)^2 So should it be more like premium invested in foreign rate - spot invested in domestic rate is the value of the forward? Also, even if you were to discount the spot back, wouldn’t you use the yr 2 spot (17.5) to discount back 2 yrs? crap, this is getting so much more confusing…

short a two-year forward currency contract on Japanese yen (JPY) denominated in ZAR at 15.00 JPY/ZAR forward rate; • this forward contract expires today; • exchange rate was 14.50 JPY/ZAR when RR entered the contract; • the spot (current) rate is now 17.50 JPY/ZAR; • compound annual interest rates for the two-year period: 1 percent in JPY and 10 percent in ZAR. Ok so the rates are already compounded for you so then the solution is this: 17.50/1.01 - 15/1.10 = 3.69 , so Read River bears the credit risk.

Grace Grace, mind posting CFAI’s answer on this? Thanks.

Sebrock, why do you discount if exchange rates if forward contract expires TODAY?

Oh, didn’t read that part. My bad, then it’s super simple. RR was short at 15 (their right to buy Yen at 15 yen/zar) and now the spot is 17.5, so they are the ones that made money in the transaction and because they need to be paid then they bear the risk because they might not get paid.

shanghai expo CFA just says Red River bears the risk and gives no detailed explanation apart from ‘based on the comparison between the forward rate 15JPY/zar and the spot rate 17.50 jpy/zar’ sebrock - is red river buying or selling yen? is the commodity shorted JPY or ZAR?

SerGrey Wrote: ------------------------------------------------------- > Sebrock, why do you discount if exchange rates if > forward contract expires TODAY? Wow – can’t believe I missed that! Was bothering me for a long time why we didn’t discount back in this question… Thanks.

sebrock Wrote: ------------------------------------------------------- > short a two-year forward currency contract on > Japanese yen (JPY) denominated in > ZAR at 15.00 JPY/ZAR forward rate; > • this forward contract expires today; > • exchange rate was 14.50 JPY/ZAR when RR entered > the contract; > • the spot (current) rate is now 17.50 JPY/ZAR; > • compound annual interest rates for the two-year > period: 1 percent in JPY and 10 > percent in ZAR. > > Ok so the rates are already compounded for you so > then the solution is this: > > 17.50/1.01 - 15/1.10 = 3.69 , so Read River bears > the credit risk. I am a level 2 candidate, and was searching for this topic and stumbled here. I hope you don’t mind. The formula you used here (SF FD) gives you the value for the long. Not short. So your logic is reversed. Don’t take my word for it, but I am looking at the formula right now in front of me. I hope I helped.

I don’t see what interest rates have got to do with this. RR just elected to forward sell 15 JPY (per ZAR) . The market value of a ZAR has gone up to 17.5 since then. So they’re effectively gaining (17.5-15)/15 =16.7% by being able to deliver less than currently required by the market. If both counterparties were to cash out, RR would be the one to receive the cash hence RR is exposed to the credit risk.