Currency Confusion

CFA Level III Derivatives
#1

CFA Text, paraphrase:

  • When due to receive cash flows denominated in a foreign currency we are long the currency and need to go short a currency forward
  • When due to purchase a currency (pay an obligation) they are short the currency and need to go long a futures contract

Qbank Answer

  • A forward currency purchase is equivalent to being long in the foreign currency cash receiving the foreign currency risk free rate and short in the domestic currency cash paying the domestic currency risk free rate.

These seem to conflict…is the second one (qbank) jsut wrong?

Also can someone give me the nutshell explanation of how the risk free rate ties in?

#2

this is from the Schweser Books.

Receive Payments (exporter) - Long Currency - Sell the Future

Pay Currency (importer) - Short Currency - Buy Future

#3

So whats up with that qbank answer then?

#4
  • A forward currency purchase is equivalent to being long in the foreign currency cash receiving the foreign currency risk free rate and short in the domestic currency cash paying the domestic currency risk free rate.

you bought the foreign currency. so you receive the foreign interest rate.

you bought the foreign currency by selling the domestic currency. so you are paying the domestic interest rate - which is the domestic risk free rate.

#5

Also, as an addition to anyone who reads this,

If you hedge the foreign stock market return, but not the currency return you receive the foreign risk free rate.

If you hedge both, you receive the domestic risk free rate.

#6

But to beat the dead horse, is the Qbank answer just wrong?

It says “a forward currency purchase is equivalent to beign long…”

The text says “When due to purchase a currency (pay an obligation) they are short the currency and need to go long a futures contract”

The Schweser books according to the other poster say

Receive Payments (exporter) - Long Currency - Sell the Future

Pay Currency (importer) - Short Currency - Buy Future

Both texts say you are short, but the answer says you are long…what am i missing…

#7

one says buy forward the other says “pay currency”

#8

ok so maybe I dont understand what a forward currency purchase means

The Question is:

which is most correct regarding “purchsing forward currencies”…

Answer is what I stated above :

A forward currency purchase is equivalent to being long in the foreign currency cash receiving the foreign currency risk free rate and short in the domestic currency cash paying the domestic currency risk free rate

To be long the currency we would have to be recieving the cash flows and would need to short a future…how does that jive with “a forward currency purchase”

#9

forward currency purchase - what I understand - you are saying you will be BUYING the FORWARD contract on the currency.

If you need to be BUYING the FORWARD contract - you need to be SHORT the currency.

#10

if you are purchasing the foreign currency then purchase the forward…easy

why? b/c if it goes up you are worse-off, so you are effectively short the currency so you want to buy the forward to hedge the risk of it increasing on you

#11

ok it makes sense now , its saying one is long the forward, soo they are long the currency…

Its not saying one needs to be short domestic, its saying one is short domestic…

If we needed ot offset the position then we would go short foreign…

#12

To keep it simple and straightforward, I would consider Foreign Currency just as another asset. (Its “price” – foreign exchange rate can changeover time)

#13

one last question with regards to currency forwards.

i am us investor, have yen investment, want to hedge currency risk of converting back to usd.

short forward (sell yen) USD/YEN

or long forward (buy usd) YEN/USD.

is this the same?

im just very confused bc i remeber that there was a 2009 exam where a canadian investor had EUR investments and he went LONG THE FORWARD!..

please help!! thank you!

#14

If you expect to convert JPY 10000 to USD in one month at rate of 100 YEN/USD, you go short on YEN 10000 forward or go long on USD 100 forward. Looking at this forward as swap could remove the confusion that clearly spells out currency you pay and receive. Remember swap is nothing but a series of forwards.

#15

SORRY FOR ASKING AGAIN… i just need to make sure i understood this.

if i go short the currency forward JPY, because i am afraid the jpy will be worth less, right?

so i am basically worried, that JPY/USD increases or put it in other way USD/JPY decreases. one jpy buys less dollars.

so then if i fixed to sell the yens at 1/100 usd/yen and the yen increases, is worth more, i will not profit fromt that because i fixed the rate, right? but if yen depreciates i am fine.

so no upside, but downside protection?

#16

Sounds right. Forward contract locks the exchange rate.