Traps in calculating the credit risk of a currency forward contract

CFA Level III Derivatives
#1

Evaluate credit risks in a currency forward contract or a foreign exchange forward contract.

1, The typical question is to calculate the value to long(to buy foreign currency) and decide who bears the risk. 2, To make life easier, use one unit of foreign currency as the notional principal. 3. Stay cool when the foreign currency is $ and the manager short the contract. 4. 1.5 years remaining == 2 year contract and 6 months into the contract.

CFAI Curriculum, Volme 5, page 255, example 8.1. Should “per $1 notional principal” be “1 euro notional principal”?

#2

I go with :

remember your formula for calculating the value of a Future’s contract

F = S * (1 + Rdc )^T / (1 + rfc )^T

where F and S are expressed as DC/FC.

Now morph it around:

S/(1+rfc)^T - F/(1+Rdc)^T

so if S and F are expressed as 0.862 / Euro and 0/90 /Euro

DC = $ and FC = Euro.

And this is the value to the LONG.

#3

thx…

Questions is why discount the SPOT rate to the present value…after all its in inherent in the SPOTRate to be the present rate…so from my understanding by discounting the spot rate one period back and the forward ratealso one period back, it will result in an incremental discount of the spot vs the forward rate.

I understand the reason behind discounting the forward rate to today to find the value in the contract TODAY, but why do we also have to discount the SPOT RATE back one period?

Thx in advance

#4

You are just applying CIRP ( covered interest rate parity ) that governs the fair value relationship in Fx forward contracts

Sf(1+Rd)^T=F(1+Rf)^T

Left side is a loan taken to fund the Fx in domestic terms , right side is a deposit of the funds in the foreign currency at the foreign rate .

Think of it like taking out a loan in the investor’s base currency to invest in a CD in the foreign currency.

If the foreign rate is high , you ask a smaller F i.e. the currency sells at forward discount.

If the foreign rate is low , you ask a larger F , i.e teh currency sells at forward premium.

Then re-arrange the relationships to get the S-F - F-D relationship . sorry for using the acronym.