A German portfolio manager entered a 3-month forward contract with U.S bank to deliver 10,000,000 for Euros at a forward rate of Eur0.8135/. One month into the contract, the spot rate is Eur0.8170/, German risk free rate is 3.5% and US risk free rate is 4%. 1) Determine the value & direction of any credit risk. 2) Any changes in your calculation if manager is receiving on forward contract (Long).
Choices were not given in the book. Just created my own but please support your answer with explanation. A. 41,294 - counterparty exposed to cr. Risk B. 35,000 - portfolio manager exposed to cr. Risk C. 28,278 - counterparty exposed to cr. risk
German PM has to deliver $10,000,000 USD in 3 months (short USD) so it had to buy USD Long at a 3 month forward at .8135euro/1USD. Which is 8,135,000EUR. One month later the the dollar appreciated to .8170euro/1USD. Because the German PM entered intro a contract to buy USD at .8135euro/USD and the spot appreciate to .8175euro/USD they are entited to .8175euro -.8135euro = .0035 euro x 10,000,000 = 35,000 euros. Because the german PM is entitled to the money it suffers from counterparty risk.
C. 28,278 German is set to deliver $10,000,000 in 3 months to US Bank, which at the forward rate is 8,135,000 Euros. 1 Month into the contract, the spot value in Euros of the $10,000,000 is 8,170,000 One month into the contract the German is 35,000 Euros better off than at initiation of the contract. But the contract value and the current value must be discounted at their respective rates. Thus the answer is: Credit Risk = [8,170,000 / (1.04)^(1/6)] - [8,135,000 / (1.035)^(1/6)] = 8,116,768.63 - 8,088,490.86 = 28,277.77 The US Bank is exposed to this risk.
Thanks BiPolarBoyBoston & CardShark Ans is C. CardShark why do we need to discount spot value? shouldn’t we just discount forward value and compare it to spot. In your ans spot value is discounted at US rfr rate and forward value at German rfr rate. How to decide which discounting rate to use for each cashflow. Part B of the question relates to this query B) If portfolio manager is long on $ on forward contract which discounting rate to use for each cashflow?
It does not matter. Valuation of a Forward Currency Contract. I am writing this from Level II material standpoint, so pardon me… I remember this as follows: F=S*(1+Rdc)/(1+Rfc) where S and F are defined as DC/FC the switch around S/(1+Rfc) - F/(1+rdc) ==> Value at any point in time. In this case S and F were defined as Euro/Dollar So S/(1+rDollar) = 0.817/(1.04) F/(1+rEuro) = 0.8135/(1.035) Reason is --> you need to borrow at 1 rate to satisfy your requirement for the other currency at its rate. So these borrowing costs need to be adjusted.
Thanks cpk123
Assuming unchanged exchange rates, Euro 35,000 credit risk at the end of 2 months from today so credit risk as of today is discounted value of 35,000
Can somebody plz explain why you use the USD rate on the inflow PV calc?