in the mock exam, Speckley wants to lock in the exchange rate of 1.25USD/EUR because he’ll convert EUR to USD in 360 days USD rate is 3% EUR rate is 3.5% so I assume that he should enter into a currency forward of long USD at the rate of 1.25*(1+3%)/(1+3.5%) = 1.244 (please correct me if I’m wrong) the question is: before maturity, the market value of the long position is $149000. The credit risk from Speckley’s perspective is closest to what? because the EUR that Speckley owns is worth $149000, Speckley can only receive 124400, so he is out of the money, from his perspective, the counterparty has zero probability to default. that part is ok with me. However, I want to go one step further, if he defaults, the counterparty should suffer a loss of _______________? (A) 149000-124400=24600 (B) 149000 © 37250
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Think about it this way… If you and I agree to this deal, and come expiration time you stand to make the money and then i’m going to have to pay you. But since I owe you so much money I can’t cover it an I sketch out of the deal. If I sketch out, the deal is off, and you don’t have to pay me (you’d be stupid to, becuse I’m sure as heck not going to pay you what i owe). So in that sense the only thing your losing is the difference between our payments. You were going to pay me 124,400 and I was going to pay you 149,000. But I don’t pay, and you don’t pay. If you didn’t pay you don’t lose the 124,400. So your actual “loss” is just the difference. 149,000 - 124,400 = 24,600
I agree with you, but the CFA institute says the answer should be 149000, that scared the shit out of me If CFA institute use wrong answers to test us, some will be screwed.
well, i think they asked about the credit risk not necessarily the “loss” sustained. not that it should really make a difference. But also, this is a currency forward right? and I don’t think people typically settle in cash on currency forwards, they actually need the money in euros or whatever, so if the counter party defaults you don’t get your 149k euros in the end go with CFAI.
CF_AHHHHHHHHH Wrote: ------------------------------------------------------- > well, i think they asked about the credit risk not > necessarily the “loss” sustained. not that it > should really make a difference. But also, this > is a currency forward right? and I don’t think > people typically settle in cash on currency > forwards, they actually need the money in euros or > whatever, so if the counter party defaults you > don’t get your 149k euros > > in the end go with CFAI. you are thinking about swaps. in a currency swap you want access to the currency. a forward is just a bet on the currency directionally.
ya you’re right… fml