The forward outright adjustment to the Spot price: Spot EURUSD 1.1746 6 month (182 days) forward outright rate: Amount: EUR 6,000,000 182 days off-shore US dollar deposit interest rate = 2.25% 182 days off-shore EUR deposit interest rate = 1.32% The forward outright price is the spot price adjusted by some amount. The adjustment is the interest rate differential between the 182 day off-shore US dollar deposit rate and 182 day off-shore EUR deposit rate recalculated from an interest rate to an exchange rate. This is done by the following: (work these vertically: EUR in one column and USD in another column) Example: Spot: EUR6,000,000.00 1.1746 USD7,047,600.00 LUSD equals EUR 6.0mm times 1.1746) Times: 1.32% 2.25% Interest: EUR40,040.00 USD80,166.45 _LEURS.Omm X 0.0132 X 122/360 ) = EUR40,040.00) P&I: EUR 6,040,040.00 USD7,127,766.45 182 day outright exchange rate: 7,127,766.45/6,040,040.00 = 1.180086 So based on a spot price of 1.1746 with current deposit rates of 1.32% for EUR and 2.25% for US dollars. the spot exchange rate is adjusted by +0.0054859 pips (1 pip = 0.0001 in exchange rate terms). When the 0.005486 is added on to the spot price of 1.1746, 182 day forward outright exchange rate = 1.180086. Stated another way, the interest rate differential between off-shore US dollar deposit interest rates and off-shore EUR deposit interest rates is: 2.25 -1.32 = 93 or 93 bps or 0.93%. 0.93% expressed as an exchange rate = 0.005485 pips. Think of it this way: I agree to buy EUR from you 182 days from now. You owe me EUR and I owe you US dollars. You can invest the EUR you owe me (you haven't given them to me yet) for 182 days at 1.32%. I can invest the US dollars (I haven't given them to you yet) for 182 days at 2.25%. Because I earn more than you (I have the higher interest rate) you want to be compensated for this difference. Given a spot of 1.1746. An outright price of 1.180085. US dollar deposit interest rates of 2.25% for 182 days and 182 days EUR deposit interest rate of 1.32%, you would be indifferent between holding US dollars or EUR for 182 days with the forward outright exchange rate of 1.180086. Homework #3: 1. Given the following information, there is an arbitrage opportunity (that is, something is not right in the given data. An arbitrage is data not in equilibrium... that is an opportunity exists to make money without risk if you are very quick (the market will adjust to equilibrium at some point) Show how you would make money on this scenario and how much would you expect to make? EUR 4,500,000.00 Spot exchange rate: 1.1705 US dollar deposit interest rate for 270 days = 2.33% EUR deposit interest rate for 270 days = 3.35% 270 days Forward outright adjustment to spot = -0.0017 270 days forward outright EURUSD exchange rate = 1.1688 2. You work for a bank and have a client/company who has contracted to buy unfinished goods from the United Kingdom. Their purchase agreement states they will pay GBP1,000,000 in 90 days for the unfinished goods. a. Provide the client/company the following: i. What is their risk in this scenario? ii. Three hedging alternatives to reduce or eliminate their currency risk
