I just went through this question this morning and had some of the same problems. James, thanks for posting you process, it made a lot more sense. Out of the entire 2009 exam, that is the only question I had major difficulty with. I am retaking Level III and somehow currency stuff has dogged me through all of the exams. Mark
Thanks James.!!!
weirdo Wrote: ------------------------------------------------------- > @james… > > maple leaf is long on a forward contract to buy 50 > million euro… > > PV inflows = 1.63/(1.03)^0.5 > > Pv outflows = 1.64/(1.045)^0.5 > > pv inflows - pv of outflows=0.001786 > > > but the CFA answer does it the opposite and gets a > negative 0.001786…i want to understand why? > > generally its assumed that since maple leaf is a > candian company it would want to sell 50 million > euro for canadian dollars in the forward market to > hedge the risk…in this case it would have made > sense for the counterparty to have the credit > risk…but here maple leaf is going long the > euro… hey weirdo, got this wrong, too…this is really confusing, I m quite sure we learned that in L2, though …
Hi James, Thanks for the explanation. I have a very quick question. With your above forumla, how do we know which interest rate to divide them with to get the PVs? Didn’t quite understand that part.
sparty419 Wrote: ------------------------------------------------------- > Hi James, > > Thanks for the explanation. I have a very quick > question. With your above forumla, how do we know > which interest rate to divide them with to get the > PVs? > > Didn’t quite understand that part. Hey James, same request as sparty419, please? How do you pick up int rates to be used to get the PV, based on whether it is buying or selling the ccy? Is the spot always discounted at the foreign rate and the fwd (contract price) always discounted at the domestic rate? Thanks, M.
Thanks everyone. I am new here. Spent entire weekend reading thru. You guys are very helpful. I think I have a more intuitive way now. In the question, the manager has entered into a forward to deliver 1,000,000 euros for dollar. After 30 days the exchange rate is euro 1.58/per dollar. 1. I understand the forward as the mgr currently is long the 1m euro and is going to convert to USD at the expiration of the forward. 2. He effectively sold his EUR at 1.51. On valuation date, EUR devalued to 1.58. Since he sold higher than spot, he has gains which is the credit risk. 1m/1.51 = 662 (sold EUR for 662 USD) vs 1m/1.58 =633 (now worth only 633) 3. If it is a multiple choice question I will stop here, since the interest rate is very close. He gained 29k w/o considering interest. If it is an essay, then I will have to use the interest. This is the part gets me. I will try to remember the formula this way, since in 1) we determined he is long EUR. He hadn’t converted yet, so he is still long 1m EUR. We can use 1m EUR / 1.03^0.5 to get PV then convert to USD using contractual exrate at 1.51. This is eql to $662/ 1.03^0.5 If he doesn’t have the forward, in order to deliver 1m EUR worth of USD, he would convert his EUR at spot and holding USD to gain US rate. Nothing new. Just my way to remember it.
malek_bg Wrote: > > Is the spot always discounted at the foreign rate > and the fwd (contract price) always discounted at > the domestic rate? malek, Agree with you. The logic is that the fwd contract has already determined the amount of domestic currency you go to pay or receive in the future in a long/short currency forwards position, respectively. So the fwd price should be discounted at domestic rate. On the other hand, the spot side assumes u exchange at spot and obtain the foreign currency instantly. Therefore, it should be discounted at foreign rate. BTW, make sure using the indirect method for the spot and fwd rates, which is: Exchange rate = domestic currency value / foreign currency value This way is more transparent for the calculation than direct method. I have seen CFAI tricked people in the old exam by providing the direct method.
Hi Malek_bg You are right, that the spot rate is always discounted using foreign int rate and the fwd contract always at the domestic int rate. Not sure the reason but most maybe bec you enter into a forward contract in the home country, usually. Here’s how I resolve to deal w this type of question: 1) Enter into forward contract to buy FC: Value to the mgr = Sell spot discount at foreign int rate - Buy forward discount at domestic int rate (i.e you close a buy contract by selling in the spot mkt - assuming the short seller defaulted and fail to deliver) 2) Enter into forward contract to sell FC: Value to the mgr = Sell forward discount at domestic int rate - Buy spot discount at foreign int rate. I am going to forget about the PV inflow and outflow bec it is too confusing and the above works for both buy and sell forward contracts examples.
thanks guys for your replies. just got a question in my mind, what if CFAI asked us for the credit risk for a future instead of a fwd? would the answer be 0 because of the clearinghouse being the counterparty of each? or should be compute be do some calculus accounting for the last margin call…? you know the stuff we learned in L2 and even L1, I guess… Thanks, M.
The best way to approach this is to figure out what you’re trying to accomplish, the cash inflows will dictate which discount rate to use. The steps provided by James@Houston are excellent at simplifying this type of problem If you’re long a foreign asset and have concerns about it’s currency depreciating; you want to hedge by selling the foreign currency and buying the domestic currency in the forward market. Since you’re buying (an inflow) the domestic currency in the forward market, you have to discount the inflow value with the rate in the domestic market. ex. a US Investor with a yen denominated portfolio would sell forward Yen and RECEIVE US$, hence would discount the value at the same rate in which the inflow is dominated, the (US$). But if you’re a US company that has a financial obligation due in a foreign currency (say, non US$ debt maturing in 90 days). Then you will sell the US forward and RECEIVE the foreign currency. The position in the long foreign currency forward is discounted at the foreign rate, rather than the US rate. ex. a US company with debt maturing in Germany would sell US and buy Euros in the forward market. Since the inflow (to pay Euro maturing debt) is denominated in a foreign currency, discounting at the foreign rate is required.
Futures are regulated. You don’t have credit risk since your counter party is the clearing house, which represents the law / Gov. How they are going to issue margin call and kill the guy really doing the buz with you is out of scope of CFA. What? You don’t trust Gov/Congress? God bless. 
malek_bg Wrote: ------------------------------------------------------- > thanks guys for your replies. > > just got a question in my mind, what if CFAI asked > us for the credit risk for a future instead of a > fwd? would the answer be 0 because of the > clearinghouse being the counterparty of each? or > should be compute be do some calculus accounting > for the last margin call…? you know the stuff we > learned in L2 and even L1, I guess… > > Thanks, > M.
Just to share my opinion for how to remember that we have to discount the spot price by the foreign rate and the forward price by the domestic rate. Fw = Spot * (1+Rd) / (1 +Rf). Now bring this b**ch down, i.e. Fw/ (1+Rd)=Spot/ (1+Rf), and so you have that the counterparty who is long the forward would like that Spot/ (1+Rf) - F/ (1+Rd) > 0.