foreign exchange forward contract

CFA Level III Derivatives
#1

Schweser Bk 4, solution to Q11, Pg 89.

Can anyone kindly help me understand how the long position for the bank has determined.

AS I understand from the question.

The US bank will buy $ and sell EUR.

In the formulae the EUR is provided in the number as that is the rate for forward contract.

Given the above how can we decided who is long the contract.

I am not able to understand how in the solution the US bank has been taken to be long basing on which flow in the forward contract.

Kindly help

Thank you

#2

All,

I have tried to understand this myself but looks like beyond me.

So the first question which I have his, how will be decide who is the long counterparty and secondly how do we know if the currency pair has been provided which can be applied to the below formulae.

Kindly help

Question

A German portfolio manager entered a 3-month forward contract with a U.S. bank to deliver 10,000,000 for euros at a forward rate of€0.8135/. One month into the contract, the spot rate is €0.8170/$, the euro rate is 3.5%, and the U.S. rate is 4.0%. Determine the value and direction of any credit risk.

Answer

The German manager (short position) has contracted with a U.S. bank to sell dollars at €0.8135, and the dollar has strengthened to €0.8170. The manager would be better off in the spot market than under the contract, so the bank faces the credit risk (the manager could default). From the perspective of the U.S. bank (the long position), the amount of the credit risk is:

vbank (long) =(€8,170,000/(1.04)2/12 ) – (€8,135,000/(1.035)2/12) = €28,278

(The positive sign indicates the bank faces the credit risk that the German manager might default.)

We discount each cash flow from the perspective of who would receive it or would effectively receive it. The German manager will receive €8,135,000 under the contract, so we discount that amount at his domestic rate (the Euro rate) of 3.5%. The €8, 170,000 is the amount the manager would receive in the spot market, so he is giving up that amount under the contract (effectively paying it to the bank). We therefore discount the €8, 170,000 at the bank’s domestic rate (the U.S. rate) of 4%.

#3

€ manager - short enters forward @ €.8135/ due in 2mo. current spot is €.817/$.here € manager is paying fewer € than what spot offers.

future grows at managers dc and spot grows at banks dc. discount them back respectively.

-(.817/1.04^1/6 - .8135/1.035^1/6) - negative potential so the opposite party bears the credit risk

let me try: u always start wîh the manager and what he wants 2) stick the currency he wants in den 3) apply spot - forward (discount as appropriate) 4) if mgr short apply negative sign 5) infer that a negative potential is going to make the counterparty bear the credot risk

#4

As for who is long and who is short - the manager entered the contract to deliver USD, so he’s short USD. The rate is quoted in EUR/USD…and the term long/short is always with respect to the base currency. So since USD is the base and the manager is short USD via the contract, he is short the forward. Hope that helps. I think the key is knowing long/short refers to the base currency.

#5

This is the important point. If the currency quotes were inverted, the long would become the short and vice versa. It just depends on your point of view.