In this question, the currency forward contract, the answer says that the London Security House is bearing the credit risk in this case as they are the one owed(or paid) at current prices.
1.) I inverted the currency rates to have Pound/Euro and the forward was .689655 and the Spot is .714286.
2.) Kalton corp is buying Pounds at the lower forward rate.
3.) Why isn’t it that Kalton is owed in this case?
4.) It states in the answer that London S.H is the one that is owed and has the credit risk.
I think you are just reading the question incorrectly. The exchange rate currently is 1.4 Euro to 1 Pound, but Karlton has agreed to purchase the Pound at a rate of 1.45 Euro for 1 Pound.
Effectively, London Securities House can go to the market, with 1.4 Euros, buy 1 Pound, then turn around and sell the Pound to Karlton for 1.45 Euro, effectively earning 0.05 Euro in arbitrage. As a result of this, LSH has “won” in this deal and thus bears the credit risk.
I guess I was assuming that the Kalton was a UK investor and so the UK investor has inverted rates…is that correct?
I guess tho, I was wrong in reading that, and as I write this I realize…Why would a UK investor be buying pounds in the forward market if they already have pounds…right?
Is part of the assumption here that because they are buying pounds, they are starting with Euro currrency? The Euro currency has appreciated and therefore the LSH is better off as you said in your response, therefore they have the credit risk.
A UK investor who wants Pounds would buy Pounds in the forward market if they needed to hedge risk of foreign currency. A UK investor who thinks the Pound will depreciate against another currency could sell GBP forward. There is no guarantee what any investor will do just based on the country they are in.
Just focus on the question. It says Karlton wants to buy Pounds and agrees to at 1.45 Euro/1GBP; therefore, LSH has agreed to sell Euro for 1.45/1GBP Pounds. At the end of the transaction, LSH can take 1.4 Euro and buy 1 Pound at the current market rate and instantly sell them to Karlton for 1.45 Euro netting 0.05 Euro for each Pound.