Forward Rates Bill Reese International Finance 1

Learning Objectives In this unit we will learn:  Why people might trade forward exchange rate contracts  How covered interest arbitrage determines forward rates  What interest rate parity is 2

Spot vs. Forward Rates Spot Rate  The price of a currency in terms of another currency for a trade today Forward Rate  Price agreed upon today for a trade to be executed at a specified future date (30, 60, 90, 180 or 360 days) 3

Forward Rates Purpose: to lock in an exchange rate and thus eliminate XR risk XR risk: the risk that the XR may move in an unfavorable direction  Risk averse investors may prefer certain forward rate to risky future spot rate 4

Forward Rate Example Purchasing manager for Best Buy  Places an order for 10,000 Sony televisions for Christmas  Must pay Sony in 6 months when delivered – pay in Yen  Agreed price is ¥300 million 5

Forward Rate Example Spot XR is.008 $/¥ ¥300 million x.008 $/¥ = $2.4 million Suppose yen appreciates to.010 $/¥ ¥300 million x.010 $/¥ = $3 million XR loss of $600,000 6

Forward Rate Example Note: $/¥  When yen appreciates, XR increases Yen is currency being priced Currency in denominator  Yen buys more dollars  Takes more dollars to buy a yen 7

Forward Rate Example Suppose 180-day forward contract is available at.0085 $/¥  Agree to sell dollars (buy yen) in 180 days at ¥/$ (1/.0085 = ) 8

Forward Rate Example Buy ¥ 300 million at.0085 $/¥ for $2,550,000 Locked-in price No XR risk 9

Forward Contracts Like Girl Scout Cookies  Order taken for future delivery specifying: Good Quantity Delivery date Price 10

Forward Contracts Usually with banks Individually tailored No money exchanged at time of agreement Counterparty risk 11

Forward Contracts Forward premium  Forward rate > spot rate Forward discount  Forward rate < spot rate Our example  Spot rate =.0080 $/¥  Forward rate =.0085 $/¥ Forward premium 12

Forward Contracts Forward premiums and discounts  Indirect quotes Premium (discount) = SR – FR x 360 FR length = 125 – x 360 = 12.5% Negative value would be a discount 13

Forward Rates Forward rate ≠future spot rate (necessarily) Determined by absence of arbitrage condition  Covered interest arbitrage 14

Example Spot rate =.73 $/CD Six-month forward rate =.73 $/CD U.S. interest rate = 5.0% Canadian interest rate = 5.5% 15

Today Borrow $100 at 5% in U.S. Convert to CD at spot rate: $100 ÷.73 $/CD = CD Invest CD in Canada at 5.5% for six months Enter into 6-month forward contract to sell CD at.73 $/CD 16

Six Months from Now Investment grows to CD (1+.055/2) = Convert CD to $ with forward contract CD x.73 $/CD = $ Pay off debt $100 (1+.05/2) = $

Covered Interest Arbitrage Started with nothing Ended up with something  Paid off debt of $ with $ from forward contract – leaving $0.25 Riskless profit Cannot last in competitive markets 18

Covered Interest Arbitrage Investors will notice Everyone buys CD in spot mkt  CD appreciates Everyone sells CD in forw mkt  CD sells at forward discount Rates adjust until arbitrage opportunity disapears 19

Interest Rate Parity Prevents covered interest rate arbitrage Country with higher interest rate  Currency sells forward at a discount 20

Interest Rate Parity (1 + i) = Forward Rate (1 + i*) Spot Rate Where i = domestic int. rate and i*= foreign int. rate 21

Interest Rate Parity (1 +.05/2) = Forward Rate ( /2).73 $/CD Solving for forward rate: $/CD Gives you just enough to pay off the loan ($102.50) 22

Interest Rate Parity Country with higher interest rates Currency sells forward at discount Eliminates possibility for covered interest arbitrage Transactions costs and taxes leaves range for forward rate 23