With regards to currency forwards- I actually have a decent understanding of how they work- definitely understand how to calculate a forward price…but I can across an example that basically said:
US RFR=5%, Japanese RFR=2%…calculate forward price and value of contract 90 days in. I understand how to calculate the forward orice based on the two RFRs given (and we were given a spot rate).
But if given a new spot rate 90 days later, the new value of the forward is calculated as:
-
discount the new spot rate by the Japanese RFR
-
discount the spot rate in play when the contact was initiated using the US RFR
Why do we use the 2 different RFRs as shown above? Why can’t we just take the difference between the 2 spot rates & discount back using 1 and only 1 RFR?
thanks!
You should use current rates. Is it possible that the current US rate has not changed since inception?
The fact is, there’s a lot more going on than merely discounting different spot rates with different risk-free rates.
I wrote an article on this – one of the first I wrote – once I figured out what, exactly, was going on (which is never explained in the curriculum); you can find it here: http://financialexamhelp123.com/valuing-a-currency-forward-whence-came-that-formula/.
(Full disclosure: as of 4/25/16, there’s a charge for reading the articles on my website. If you want to get an idea of what the articles are like, take a look at the free sample articles here: https://www.financialexamhelp123.com/sample-articles/.)
this is an example of what I’m talking about:
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