Question
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
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 (USD equals EUR 6.0mm times 1.1746)
Times: 1.32% 2.25%
Interest: EUR40,040.00 USD80,166.45 (EUR6.0mm X 0.0132 X 182/360 ) = 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 havent given them to me yet) for 182 days at 1.32%. I can invest the US dollars ( I havent 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
- 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.
- Provide the client/company the following:
- What is their risk in this scenario?
- Three hedging alternatives to reduce or eliminate their currency risk.
- Provide the client/company the following:
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