Can someone explain why Q1 on page 255 of Risk Management uses the foreign risk free rate to discount the spot and not the domestic rate? CFAI says to use the foreign to discount the spot and the domestic rate to discount the forward. Any help would be much appreciated!
I though it was foreign with spot and domestic with forward, no?
Is it? That’s my question. Is that a hard and fast rule?
F = S * (1+R_d) / (1+R_f) when measured in domestic currency per unit local currency. Divide both sides by (1 + R_d) --> F/(1+R_d) = S/(1+R_f). Subtract the term on the right to have F/(1+R_d) - S/(1+R_f) = 0.
mp2438 Wrote: ------------------------------------------------------- > F = S * (1+R_d) / (1+R_f) when measured in > domestic currency per unit local currency. > > Divide both sides by (1 + R_d) --> F/(1+R_d) = > S/(1+R_f). Subtract the term on the right to have > F/(1+R_d) - S/(1+R_f) = 0. Then if F/(1+R_d) - S/(1+R_f) > 0, who bears risk (long or short) ? why ?
^ the formula above means you are long forward, so if the value > 0, then you have credit risk because someone owes you some amount, and they can default on it.
mp2438, TKVM !