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CHAPTER 5 PART 2 - THE MARKET FOR FOREIGN EXCHANGE

ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

5. What is meant by a currency trading at a discount or at a premium in the forward market? Ch 5

Part 2

Answer: The forward market involves contracting today for the future purchase or sale of foreign
exchange. The forward price may be the same as the spot price, but usually it is higher (at a
premium) or lower (at a discount) than the spot price.

7. Banks find it necessary to accommodate their clients’ needs to buy or sell FX forward, in many
instances for hedging purposes. How can the bank eliminate the currency exposure it has created
for itself by accommodating a client’s forward transaction? Use an example to illustrate your answer.
Ch 5 part 2

Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To

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illustrate, suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange
rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will
lend the dollars for three months until they are needed to deliver against the dollars it has sold
forward. The British pounds received will be used to liquidate the sterling loan.

PROBLEMS

2. Using the American term quotes from Exhibit 5.7, calculate the one-, three-, and six-month
forward cross-exchange rates between the Australian dollar and the Swiss franc. State the forward
cross-rates in “Australian” terms. Ch 5 part 2

Exhibit 5.7 figures:

Spot 1 month forward 3 month forward 6 month forward

$/A$ .7113 .7117 .7125 .7139
$/SFr 1.0018 1.0047 1.0104 1.0193

Solution: The formula we want to use is:

FN(AD/SF) = FN($/SF)/FN($/AD)

F1(AD/SF) = 1.0047/.7117 = 1.4117

F3(AD/SF) = 1.0104/.7125 = 1.4181
F6(AD/SF) = 1.0193/.7139 = 1.4278

3. A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£
exchange rate was 1.55. Subsequently, the exchange rate has changed to 1.61. Is this movement in
the exchange rate good from the point of view of the position taken by the trader? By how much
has the bank’s liability changed because of the change in the exchange rate? Ch 5 part 2

CFA Guideline Answer:

The increase in the $/£ exchange rate implies that the pound has appreciated with respect to the
dollar. This is unfavorable to the trader since the trader has a short position in pounds.
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Bank’s liability in dollars initially was 5,000,000 x 1.55 = $7,750,000

Bank’s liability in dollars now is 5,000,000 x 1.61 = $8,050,000

12. The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. Based
on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be
$1.92/£ in three months. Assume that you would like to buy or sell £1,000,000. Ch 5 part 2

a. What actions do you need to take to speculate in the forward market? What is the expected
dollar profit from speculation?

b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns
out to be $1.86/£.

Solution:
a. If you believe the spot exchange rate will be $1.92/£ in three months, you should buy
£1,000,000 forward for $1.90/£. Your expected profit will be:
$20,000 = £1,000,000 x ($1.92 -$1.90).

b. If the spot exchange rate actually turns out to be $1.86/£ in three months, your loss from the
long position will be:
-$40,000 = £1,000,000 x ($1.86 -$1.90).

13. Omni Advisors, an international pension fund manager, plans to sell equities denominated in
Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African
rands (ZAR).
Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk
that the ZAR will appreciate relative to the CHF during this 30-day period. The following exhibit
shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD). Ch 5 part 2

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Currency Exchange Rates

ZAR/USD ZAR/USD CHF/USD CHF/USD
Maturity Bid Ask Bid Ask
Spot 6.2681 6.2789 1.5282 1.5343
30-day 6.2538 6.2641 1.5226 1.5285
90-day 6.2104 6.2200 1.5058 1.5115

a. Describe the currency transaction that Omni should undertake to eliminate currency
risk over the 30-day period.

b. Calculate the following:

• The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity
portfolio.
• The current value of Omni’s Swiss equity portfolio in ZAR.
• The annualized forward premium or discount at which the ZAR is trading versus
the CHF.

CFA Guideline Answer:

a. To eliminate the currency risk arising from the possibility that ZAR will appreciate
against the CHF over the next 30-day period, Omni should buy USD 30-day forward
with CHF and sell USD 30-day forward for ZAR).

b. The calculations are as follows:

• Using the currency cross rates of two forward foreign currencies and three currencies (CHF,
ZAR, USD), the exchange would be as follows:
--30 day forward USD are bought with CHF. Dollars are bought at the forward ask price of
CHF1.5285 = $1 (done at ask side because going from CHF into dollars)
--30 day forward USD are sold for ZAR at the rate of 6.2538 = $1 (done at bid side because going
from USD to ZAR)
--For every 1.5285 CHF held, 6.2538 ZAR are received; thus the 30 day forward cross currency ask
rate is 1.5285 CHF/6.2538 ZAR = 0.244411398 CHF/1ZAR.
• At the time of execution of the forward contracts, the value of the 3 million CHF equity portfolio
would be 3,000,000 CHF/0.244411398 = 12,274,386.65 ZAR.

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• To calculate the annualized premium or discount of the ZAR against the CHF you require
both the forward and spot ask rate and the 30 day forward ask rate. Therefore calculate
the spot ask rate similar to the way that you calculated the 30 day forward ask rate:
- USD are bought at spot rate with CHF spot ask rate of CHF1.5343 = $1 (done at ask side because
going from CHF into dollars).
- USD are sold at spot rate for ZAR at the rate of 6.2681 = $1 (done at the bid side because going
from dollars into ZAR). Therefore Spot ask rate = 1.5343 CHF/6.2681 ZAR = 0.244779120

 To calculate premium or discount:

Spot ask rate = 1.5343 CHF/6.2681 ZAR = 0.244779120
30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398

The premium/discount formula is: [(forward ask rate – spot ask rate) / spot ask rate] x (360 / # day
contract) = [(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) = -1.8027126 %
= -1.80% discount of ZAR to CHF.

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