For those using this year’s Schweser material, I’m on Page 65 of Book 4.
The second example says: "As part of a foreign exchange hedging strategy, a US portfolio manager has shorted a forward contract on euros denominated in US dollars with a forward price of $1.8095/Euro. With three months remaining on the contract, the spot rate is now $1.8038/Euro, the US interest rate is 5.5%, and the foreign interest rate i 5.0%. Determine the value and direction of any credit risk.
My thoughts thus far: A) Direction is to the benefit of the portfolio manager. The PM has a positive value, because he can buy at spot ($1.8038) and sell at the forward price that was previously “locked in” at $1.8095. This means the PM has credit risk.
B) I know that the value will be something along the lines of (spot - forward rates) and discounted for the 3 months remaining. (This will be for whomever went long, PM will see the exact opposite value)
My challenge is that the book discounts the spot exchange rate at the foreign interest rate while the forward exchange rate is discounted by the domestic rate. Why is this the case? Is it because you have to think about who is on which side of the contract - as in, the PM is a US portfolio manager whose exposure is in the USD, so you use the domestic rate for his forward exchange rate while the other uses the foreign interest rate?
Sorry if this is confusing, but any support is very much appreciated!