 © K. Cuthbertson and D. Nitzsche Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets)

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© K. Cuthbertson and D. Nitzsche Figures for Chapter 15 THE FOREIGN EXCHANGE MARKET (Investments : Spot and Derivatives Markets)

© K. Cuthbertson and D. Nitzsche Figure 15.1 : Actual FX-forward contract :cash flows t = 0 Time Receive \$150 Pay out £100 t = 1 Will receive \$150 and pay out £100 at t=1. No ‘own funds’ are used and no cash exchanges hands today (time t = 0) Quoted forward rate : F = 1.5(\$/£)

© K. Cuthbertson and D. Nitzsche Figure 15.2 : Synthetic FX-forward contract t = 0 Time (4) Receive \$150 (1) Pay out £100 t = 1 Note : S = 1.513636 (\$/£) and no ‘own funds’ are used. Using money market and the spot FX rate. Data : r(UK) = 11%, r(US) = 10%, S = 1.513636(\$/\$) Create cash flows equivalent to actual forward contract begin by ‘creating’ the cash outflow of £100 at t = 1. (2) Borrow £90.09 at r(UK) = 11% (3) Lend £90.09 x S = \$136.36 in the US at r(US) = 10%

© K. Cuthbertson and D. Nitzsche Figure 15.3a : Calculating bid rate for forward deal t = 0 Time Receive \$1 Pay out euros How much ? t = 1 Actual forward contract (bid) Bank H will receive \$1 and pay out euros at t = 1 What rate should Bank H charge for buying the base currency, USD forward - that is its BID RATE. Step 1 : Bank H actual FX forward contract.

© K. Cuthbertson and D. Nitzsche Figure 15.3b : Calculating bid rate for forward deal t = 0 Time (4) Receive euros = S(1+r EU,b )/(1+r US,O ) (1) \$1 t = 1 (2) Borrow USD = \$1/(1+r US,O ) (3) Sell these USDs for euros at spot rate (euro per USD). Hence at t = 0 lend EUROs = S/(1+r US,O ) at the bid rate r EU,b Step 2 : Hedging the forward position using spot FX and money markets. Create cash flows OPPOSITE to those in the F.C. Begin by ‘creating’ the cash outflow of \$1.

© K. Cuthbertson and D. Nitzsche Figure 15.4a : Calculating offer rate for forward deal t = 0 Time Receive euros How much ? Pay out \$1 t = 1 Actual forward contract (offer) Step 1 : Bank H actual FX forward contract.

© K. Cuthbertson and D. Nitzsche Figure 15.4b : Calculating offer rate for forward deal t = 0 Time (1) \$1 (4) will pay out = S(1+r EU,O )/(1+r US,b ) = F(offer) = 1.00553 t = 1 (2) Borrow USD = \$1/(1+r US,O ) (2) Lend \$1/(1+r US,b ) Step 2 : Hedging the forward position using spot FX and money markets. Create cash flows OPPOSITE to those in the F.C. Begin by ‘creating’ the cash outflow of \$1. To lend USDs at t = 0 we have to first borrow euros and switch them into spot dollars

© K. Cuthbertson and D. Nitzsche Figure 15.5 : Hedging a forward deal with an FX swap t = 1 t = 0 Buy \$10m (receive) Sell £6.5m (pay out) Buy £6.25m (receive) Sell \$10m (pay out) Swap points = -250 C. The FX swap (swap points = -250) t = 0 Buy £6.5m (receive) B. Spot transaction (S = 0.65(£/\$)) Sell \$10m (pay out) Receive \$10m A. The Outright forward contract Pay out £6.5m F = 0.625 (£/\$) Bank H : Cash flows (F = 0.625 £/\$, S = 0.65 £/\$, F-S = -250, hence r UK < r US )

© K. Cuthbertson and D. Nitzsche Figure 15.6 : Actual and PPP exchange rate S(\$/£) Price ratio (\$/£) - PPP exchange rate Actual exchange rate (\$/£)

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