Forward Discount Premium Forward Exchange, etc

CFA Level II
#1

I have had a hard time with this topic until I decided to put it to rest once and for all. I have determined the authors have done a poor job of linking readings 17 and 18 and their formula conventions, making it hard to follow (in my opinion). The problem is the examples in 17 are in Direct quotes and in 18 they are indirect

This is how decided to interpret and think it makes it a bit easier. Maybe I overcomplicated, but the follwing is what works for me.

I put everything in terms of S= a:b

a = quoted

x_a, = rate or inflation for a, depending on formula

x_b = " " for b

All the formulas are roughly the same F = S * (1+x_b/1+x_a)

Differentials (x_b - x_a)

For the “a” Currency–

Forward discount: Forward less that spot

discount = less = weak, i.e. “a” is weak to “b”

Question will state foreign, domestic home, base.

Everything is a:b

a:b = b/1. Every pair is x/1. Determine what the “1” is. For example-- EUR:USD = 1:1.25 = 1.25/1

If question states that FC = EUR, then FC:DC = a:b. if FC = USD, then DC:FC = 1:1.25.

so if DC:FC (a:b) where DC(a) = Forward less than spot, DC forward discount.

in short, remember in all the formulas, it is b in numerator, a in denominator

REMEMBER: for S:a:b, “b over a or b-a” , “a” forward discount when F less spot.

Then map FC:DC or DC:FC to a:b.

You can figure out any permutation of the questions from there without having to try to keep straight in your mind which is foreign, etc.

Hope this helps. If anyone finds flaw in logic, please post. I have gone over many problems and has worked for me.

#2

Choose an example and I can tell you how I do this without ever caring about direct/indirect, base, domestic, etc. Also, throw in bids and asks to make it more general.

#3

2:

example 1, reading 62

example 5, reading 18

thanks

#4

I don’t even have the books with me. Let us start with something easy:

The annual interest rates in the United States (USD) and Sweden (SEK) are 4% and 7% per year, respectively. If the current spot rate is USD:SEK = 9.5238, then the 1-year forward rate in USD:SEK is:

A. USD:SEK = 9.2568.

B. USD:SEK = 10.2884.

C. USD:SEK = 9.7985.

First the quote, USD:SEK = 9.5238. Notice that SEK is positioned next to the number 9.5238, so I would just write it as SEK 9.5238/$, and it means to buy $1 you have to pay SEK 9.5238, just like when you go to a store in Sweden and you see a price tage like SEK 10/box, it means one box will cost you SEK 10.

The forward rate is calculated as F(SEK/) = Spot(SEK/) * (1+R(SEK))/(1+R$)

notice that top currency stays on top and bottom stays on bottom.

so: F(SEK/) = Spot(SEK/) * (1+R(SEK))/(1+R$)

F(SEK/) = SEK 9.5238/ * 1.07/1.04 = SEK 9.7985/$

#5

ok. Simple enough. that is pretty much what I was doing. F _b/a = S_b/a x (1+r_b)/(1+r_a)

So then the same relationship holds for IRP and Inflation differential?

to follow your example:

F = SEK 9.7985/$

S = SEK 9.5238/$

IRP = (9.7985-9.5238)/9.5238 = (1.07-1.04)/1.04

Since SEK/$ Forward > Spot, SEK Forward Discount.

think I got it. thanks

#6

Here’s mine;

USD:xxx => Dom ccy => you are trading cry forwards so obv, you are looking at foreign mkts;

In this case, you want invest in FC, you look into rFC - rDC ti find your forward rates => 7 - 4 = + 3%

#7

in essence…

S = a:b

S(b/a) = a:b = FR(b/a) = r(b)-r(a)

USD:SEK

b= R(SEK) = 7

a= R(USD) = 4

7-4 = +3

SEK higher rate, Forward Discount to USD.