Trading in Foreign Exchanges (Spot Rates & Forward Rates)?

Please explain to me on how to do this. I am completely lost. Thank you.

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1 Answer

  • 7 years ago
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    First note that you are given the forex rates in "indirect" form. Indirect quotes tell you the number of foreign units it takes to buy 1 unit of domestic currency (your domestic currency is the US dollar). So, using the spot rate, it takes £0.5267 to buy $1. The reciprocal ( 1 / the indirect rate) will give you a "direct" quote, the number of domestic currency units (here, dollars) to buy one unit of foreign currency (here, the £). Thus, 1 / 0.5267 = 1.8961. This means £1 = (buys) $1.8961.

    Looking at the spot and forward rates....

    0.5267 ...0.5283...0.5299...0.5315

    you see the number increasing over time...this means it takes more £s to buy dollars in the future. That means the £ is expected to weaken against the dollar in the future.

    Another way to look at it is to look at the reciprocals of the spot and forward rates. 1 / the indirect quote...


    Examining these rates, you'll see that in the future the £ is worth fewer dollars. Again, this shows the £ is weakening against the dollar.

    So, the answer to #1 is the £ is selling at a discount in the forward market. (It costs less, in terms of dollars, in the future, than it costs today, at the spot rate.)

    #2) There are two ways to go about calculating the answer. The fastest way is to do it this way: Since the indirect quote is expressed as £/$ = 0.5267, then £450,000/0.5267 = $854,376 (I drop the cents since your answer options drop them). You'll see that this is the same as inverting the £0.5267/$1 to 1 / 0.5267 and multiplying by 450, you have 450,000/0.5267 = $854,376. The other way, is really another way to invert and multiply, but with one more step. You actually "solve" for 1 / 0.5267 first, which gives you the direct quote, 1.89861, which is the number of dollars per pound, and then multiply by the number of pounds: £450,000 * $1.89861 = $854,376.

    #3) First solve for the dollar value of the £450,000 at the 60 day forward rate...invert and multiply

    450,000 / 0.5299 = $849,216

    or solve for the fraction 1 / 0.5299 first and then multiply:

    1 / 0.5299 = 1.88715...times 450,000 = $849,216

    Second, solve for the difference between receiving $s at the 60 day forward rate vs receiving $s at the spot rate today...

    forward $849,216 - spot 854,376 = ($5,159) < where the parentheses indicate a negative number, e.g. a LOSS

    BTW, the fact that the question itself asks you how much you LOSE by waiting 60 days to get paid £450,000 indicates that the £ is worth LESS in the forward market than it's worth at the current spot price....just a confirmation of your answer to the first question - the £ is selling at a discount to spot in the forward market.

    I've included a link which will take you to the beginning of the foreign exchange section of the CFA exam study guide. If you click on it, you'll see there are several sections you can explore to learn more, e.g. section 5.9 basic terms of forex (the link takes you directly there), 5.11 spot market calculations, 5.12 forward market calculations, 5.8 purchasing power parity and interest rate parity. I hope you find this useful.

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