If the currency that the investor was short on in the initial forward contract has appreciated , there will be a loss .
WRT to case EUR base currency appreciated by _ + 0.0036 _
_ How it is inflow to the company? _
Nexran _ sold _ EUR20 million forward to the settlement date at 1.1716 (USD/EUR).
To mark the position to market, Nexran offsets the forward transaction by buying EUR20 million six months forward to the settlement date.
For the offsetting forward contract, because the EUR is the base currency in the USD/EUR quote,
buying EUR forward means paying the offer for both the spot rate and forward points.
The all-in six-month forward rate is calculated as 1.1243 _ + 0.0036 _ = 1.1279 USD/EUR.
This rate gives a net cash flow on settlement day of EUR20,000,000 × (1.1716 – 1.1279) USD/EUR = 20,000,000 × 0.0437 = USD874,000. (This amount is a cash inflow because the EUR depreciated against the USD.)
To determine the mark-to-market value of the original forward position, calculate the present value of the USD cash inflow using the six-month USD discount rate: = USD871,690.
I don’t have the numbers in front of me but I remember this question… apologies if I got any of the spreads wrong, but I interpreted it as follows:
USD is the price currency, EUR is the base. Going long this pair would be agreeing to buy EUR at a rate of “x” USD in the future. Because you want to hedge your exposure to EUR that you will receive in the future (i.e., protect yourself against a drop in the value of EUR,) you’re going to short the forward and lock in selling your EUR at a rate of “X” USD in the future.
At the forward contract rate of 1.1716 USD/EUR, selling your EUR is going to net you 20mm x 1.1716 = 23,432,000 USD.
At the rate some time later of 1.1279 USD/EUR, selling your EUR is going to net you 20mm x 1.1279 = 22,558,000 USD.
You’ve saved yourself 874k by taking the short forward position. Just need to remember to discount back at the EUR interest rate to get the PV of this savings.
I think the easiest sanity check on exam day is to just take a step back and remember that a short position (selling the base currency) wins if the base currency drops in value (just like the short position in a stock wins if the stock drops in value) and a long position wins if the base currency goes up in value. One EUR used to cost $1.1716, now it costs $1.1279- about 5 cents cheaper. EUR dropped in value during the contract so the person who shorted EUR is going to get paid.
So I don’t have the case in front of me…so I will give an overview generic on how these are “supposed” to be solved…
So whatever you sold you were “short”. In this case, the Euro.
To mark to market, they need to act like the are offsetting the contract. So they need to Buy Euro (what they sold, to offset).
Since we are “selling US to buy euro”, we are going down the quote, hence that is the Ask. So the Ask Spot + the forward points corresponding to that (remember, offsetting = another forward, for 3 months) is our quote.
Taking those two rates ( ) * Notation principale gives us a Cash amount. Here is the trick, the sign of that doens’t tell us anything.
We went short the Euro, so if the Euro depreciated, we won. Even if that was -200 dollars, it does not matter. We went short, we won. Then we just discount it by the currency we were left with, since the Euro’s cancled, it’s dollars, the US rate.
That being said, if I’m asked to Mark to Market a forward, I’m probably spending 2 minutes on it, going with what seems the most resonable, and coming back to it later. They are nasty to solve.
So you are selling 20 milion Coffee for $1.1716/Coffee in 12 months.
Six months goes by and you want to mark to market your position. You have six months remaining so you want to look for a six month forward which comes out to $1.1279/Coffee in 6 months. The initial contract you have also has six months remaining and you have already locked it in at $1.1716/Coffee.
Now, on one hand you could sell coffee for $1.1716/Coffee in six months and on the other hand you can buy coffee for 1.1279/Coffee. You subtract the two and you get a profit. But this profit comes at settlement date (in six months) so you have to discount it BACK using the discount rate.
= USD871,690.