Hi, Im having a hard time. Some help would be appreciated. here’s the question. Its from scweser vid 11, pt5 from the 2008 cfa exam, question 7 Red River…red River is a mining co based in south africa, and they sell there mining extracts abroad… we are asked to analyze an OTC derivative contract that Red River has undertaken… Shorted a two year forward currency contract on Japnese Yen (JPY) denominated in ZAR at 15.00 jpy/zar forward rate. we are told that this contract expires today. Exchange rate was 14.50 jpy/zar when the contract was undertaken. The spot is now 17.50 jpy/zar Compund annualy interest rates for the 2 yr period, 1 percent in JPY and 10 percent in Zar. We are then asked to Determine which party bears the credit risk, Red River or the counterparty. Here are my questions… Does this fwd contract allows red river to sell JPY for ZAR at the rate of 15 jpy/zar? Now because the spot is 17.50 jpy/zar, red river is better off with the contract, right? because theyll get 1 zar for 15 jpy, vs the spot rate of 17.5 jpy for 1 zar correct? And because of this, they face the credit risk becasue the other party could say screw you, and he’d be selling the 17.5 jpy for 1 zar, right? The actual answer, from cfa/schweser, is that Red River faces the credit risk, “Based on the comparisonbetween the forward rate of 15jpy/zar and the spot rate of 17.5jpy/zar, the short yen counterparty (RR) receives payment, and therefore RR bears the credit risk.” So I kinda get it, but honestly, the interpretation of futueres is so confusin for me especially when its phrased like so…“Shorted a two year forward currency contract on Japnese Yen (JPY) denominated in ZAR at 15.00 jpy/zar forward rate”. Can anyone dumb this down for me, or give me a trick??? Thanks allot guys/gals. Happy Sunday studying…
Please note RR is selling yen or buy zar. Buy zar at 15 jpy/zar (0.0666zar/yen).is better off than at 17.50 jpy/zar (0.0571zar/yen). 1. The fwd contract allows RR to sell JPY for ZAR at the rate of 15 jpy/zar (0.0666zar/yen). 2. When the contract expired, the spot rate (= forward rate) is 17.50 jpy/zar (0.0571zar/yen) which is lower than the contracted rate (0.0666zar/yen), therefore, RR makes profits and bear the credit risk. Does it make sense ?
thanks. kinda helps With respect to futures, whats thes easiest way to decipher which party is buying what? For RR, they “Shorted a two year forward currency contract on Japnese Yen (JPY) denominated in ZAR at 15.00 jpy/zar forward rate” Never mind the short, say they were long, the phrase, “two year forward currency contract on Japnese Yen (JPY) denominated in ZAR at 15.00 jpy/zar forward rate” means that they can buy 15JPY for 1ZAR? Is that the correct interpretation? I kinda get it. I can use the little table that Schweser made in bk4, where it states that if you are receiving foreign currenncy (ie long the foreign currency), youd short a fwd contract based on that currency (ie allowing you too sell thje foreign, and in turn get your LC). any other tricks to understand which way they are coming from?
For example, if you are receiving foreign currency (ie, long the foreign currency) in 2 years means that you will have (receive) the foreign currency on your hand in 2 years. At that time (2 years from now), you will like to exchange the foreign currency into your domestic currency. So you will short (sell) a forward contract so that you can exchange the foreign currency into your domestic currency at a predetermined (contracted) exchange rate. “two year forward currency contract on Japnese Yen (JPY) denominated in ZAR at 15.00 jpy/zar forward rate” means you will exchange JPY to Zar at 0.0666zar/yen or you will exchange Zar to JPY at 15.00 jpy/zar,. Suppose Zar is your domestic currency (1) if you long the two year forward currency contract, that shall means you will sell Zar & buy at 15 JPY/Zar (2) if you short the two year forward currency contract, that shall means you will sell JPY and & buy at 0.0666zar/yen. It depends on you are receiving the foreign currency or you are paying the foreign currency (in 2 years in above case). Hope this will help.
Correction : Suppose Zar is your domestic currency (1) if you long the two year forward currency contract, that shall means you will sell Zar & buy JPY at 15 JPY/Zar (2) if you short the two year forward currency contract, that shall means you will sell JPY & buy Zar at 0.0666zar/yen. It depends on you are receiving the foreign currency or you are paying the foreign currency (in 2 years in above case).