I am stuck on something that should be obvious - can someone please help? In CFAI Rd 37, Pg 49, Ex 8 on credit risk, why are we discounting the spot price = $0.862 by the euro interest rate? SInce this is the price of the asset (euro) right now, there should be no need to discount (as in the example discussed in second paragraph of page 47). What am I missing? Thanks.
this is simple interest pairty concept using direct qoutes (DC/FC) F/S = [1 + r(dc)] / [1+ r(fc)] or F / [1+ r(fc)] = S / [1 + r(dc)] or {S / [1 + r(dc)]} - {F / [1+ r(fc)]} = 0 the contract still has 1.5 year left, so you discount both spot and forward rates by their respective interest rates as IRP says, and see if they are out of balance, if they are, based on if the difference if it is positive(negative) then long(short) bears potential credit risk
volkovv, Glad you agree. Check out my post on q. 21 from same reading.
Hmm… how do you get from: F/S = [1 + r(dc)] / [1+ r(fc)] to F / [1+ r(fc)] = S / [1 + r(dc)] Should not it be: F / [1+ r(dc)] = S / [1 + r(fc)] ???
you’re right
tanyusha, you are right, typo on my part, it should be F/S = [1 + r(dc)] / [1+ r(fc)] or F / [1+ r(dc)] = S / [1 + r(fc)] or {S / [1 + r(fc)]} - {F / [1+ r(dc)]} = 0
That is how i approach those problems 1) calculate the forward at time t now your payoff is Ft-Fo, now discount using Rf in corresponding currnecy (dollars using dollar rf ect) I hope i am right about discounting rate 