Financial,Engineering_Currency Forwards and Futures.pptVIP

copyright: K. Cuthbertson OH-FXBasic copywrite: K. Cuthbertson Forward Market in Foreign CurrencyCovered Interest ParityCreating a Synthetic Forward Contract Foreign Currency Futures Forward Market in Foreign Currency Forward Market Contract made today for delivery in the future Forward rate is “price” agreed, today eg. One -year Forward rate = 1.5 $ / ￡ Agree to purchase ￡100 ‘s forward In 1-year, receive ￡100 and pay-out $150 Forward Rates (Quotes) Covered Interest Parity Covered Interest Parity CIP determines the forward rate F and CIP holds when: Interest differential (in favour of the UK) = forward discount on sterling (or, forward premium on the $) ( rUK - rUS) / ( 1 + rUS ) = ( F - S ) / S An Example of CIP The following set of “prices” are consistent with CIP rUK = 0.11 (11 %) rUS = 0.10 (10 %) S = 0.666666 ￡ / $ (I.e. 1.5 $ / ￡ ) Then F must equal: F = 0 ￡/ $ ie. 1.486486 $ / ￡  Covered Interest Parity (CIP) CHECK: CIP equation holds Interest differential in favour of UK ( rUK - rUS) / ( 1 + rUS ) = (0.11 -0. 10) / 1.10 = 0.0091 (= 0.91%) Forward premium on the dollar (discount on ￡) = ( F - S ) / S = 0.91% CIP? return to investment in US or UK are equal 1) Invest in UK TVuk = ￡100 (1. 11) = ￡111 = ￡A ( 1 + rUK ) 2) Invest in US ￡100 to $ ( 100 / 0.6666) = $150 At end year $( 100 / 0.6666 )(1.10) = $165 Forward Contract negotiated today Certain TV (in ￡s) from investing in USA: TVus = ￡ [( 100 / 0.666 ) . (1.10) ] 0.6727 = ￡111 = ￡ [ (A / S ) (1 + rUS) ]. F Hence : TVuk = ￡111= TVUS = ￡111 Covered Interest Parity (Algebra/Derivation) Equate riskless returns ( in ￡ ) (1) TVuk = ￡A ( 1 + rUK ) (2) TVus = ￡ [ ( A / S ) ( 1 + rUS ) ]. F F = S ( 1 + rUK )