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Hedged or Unhedged Cash Flows Unhedged cash flows and hedged cash flows using either swap or forward contracts. Unhedged 835 3.5 103.5 Swap-hedged $5.4 $5.4 $95.4 Forward $3.226 $3.304 $100.064 hedged All have PV = 100 = $90 6149 Currency Swap A currency swap is equivalent to borrowing in one currency and lending in another $90 now $5.4, $5.4, $90 Firm Market-maker 3.5, 3.5, 103.5 100 now Currency Swap: Market-Maker Market-maker use currency forward contracts to hedge the Euro interest. The position of the market-maker is summarized below Forward Exchange Year Receive Dollar Pay Hedged Net Cash Rate (SE) Interest Euro Interest Flow 1 0.9217 $5.40 -63.5 x 0.9217 S2.174 2 0.9440 $5.40 -3.5 0.9440 $2.096 3 0.9668 $95.40 103.5 x 0.9668 --$4.664 The PV of the market-maker's net cash flows is ($2.174/1.06) + ($2.096 / 1.062) - ($4.664 / 1.06) = 0 6-351 Redundant Information? $0.9 (1tusrate Current exchange rate xo is $0.90/. (1+fratte . Interest rate on euro is 3.5%. Interest rate on dollar is 6%. Question: what determines the forward exchange rates? For = xe = xo- (1+r) if given rate is effective *(1+r) Forward exchange rates are given as 0.9217, 0.9440, and 0.9668. Hedged or Unhedged Cash Flows Unhedged cash flows and hedged cash flows using either swap or forward contracts. Unhedged 835 3.5 103.5 Swap-hedged $5.4 $5.4 $95.4 Forward $3.226 $3.304 $100.064 hedged All have PV = 100 = $90 6149 Currency Swap A currency swap is equivalent to borrowing in one currency and lending in another $90 now $5.4, $5.4, $90 Firm Market-maker 3.5, 3.5, 103.5 100 now Currency Swap: Market-Maker Market-maker use currency forward contracts to hedge the Euro interest. The position of the market-maker is summarized below Forward Exchange Year Receive Dollar Pay Hedged Net Cash Rate (SE) Interest Euro Interest Flow 1 0.9217 $5.40 -63.5 x 0.9217 S2.174 2 0.9440 $5.40 -3.5 0.9440 $2.096 3 0.9668 $95.40 103.5 x 0.9668 --$4.664 The PV of the market-maker's net cash flows is ($2.174/1.06) + ($2.096 / 1.062) - ($4.664 / 1.06) = 0 6-351 Redundant Information? $0.9 (1tusrate Current exchange rate xo is $0.90/. (1+fratte . Interest rate on euro is 3.5%. Interest rate on dollar is 6%. Question: what determines the forward exchange rates? For = xe = xo- (1+r) if given rate is effective *(1+r) Forward exchange rates are given as 0.9217, 0.9440, and 0.9668