International Business Chapter 3 Cambridge University Press Forward Markets And Transaction Exchange Risk Annualized Forward

Chapter 3

Forward Markets and Transaction

Exchange Risk

QUESTIONS

1. What is a forward exchange rate? When does delivery occur on a 90-day forward

contract?

Answer: The forward exchange rate is a price quoted today for the exchange of currencies

at the maturity of the forward contract. To find the delivery date for a 90-day forward

contract, one first finds the spot value date, which is typically two business days in the

2. If the yen is selling at a premium relative to the euro in the forward market, is the

forward price of EUR per JPY larger or smaller than the spot price of EUR per JPY?

3. What do we mean by the expected future spot rate?

4. How much of the probability distribution of future spot rates is between plus or

minus 2 standard deviations?

95.44% of the probability distribution.

5. If you are a U.S. firm and owe someone ¥10,000,000 in 180 days, what is your

transaction exchange risk?

6. What is a spot–forward swap?

7. What is a forward–forward swap?

Answer: A forward-forward swap involves either the purchase of foreign currency at a

PROBLEMS

1. If the spot exchange rate of the yen relative to the dollar is ¥105.75, and the 90-day

forward rate is ¥103.25/$, is the dollar at a forward premium or discount? Express

the premium or discount as a percentage per annum for a 360-day year?

Chapter 3: Forward Markets and Transaction Exchange Risk 3

annualized forward discount is 9.46% because

¥103.25/$ – ¥105.75/$ 360 100 9.46%

¥105.75/$ 90

  = −

Notice that the word “discount” implies that the forward rate is less than the spot rate.

2. Suppose today is Tuesday, August 4, 2015. If you enter into a 30-day forward contract

to purchase euros, when will you pay your dollars and receive your euros? (Hints:

September 4, 2015, is a Friday, and the following Monday is a holiday.)

Answer: To determine the value date of the forward contract, which is the day on which the

exchange of currencies happens, one must first find the spot value date. For dollar-euro

3. As a foreign exchange trader for JPMorgan Chase, you have just called a trader at

UBS to get quotes for the British pound for the spot, 30-day, 60-day, and 90-day

forward rates. Your UBS counterpart stated, “We trade sterling at $1.7745-50, 47/44,

88/81, 125/115.” What cash flows would you pay and receive if you do a forward

foreign exchange swap in which you swap into £5,000,000 at the 30-day rate and out

of £5,000,000 at the 90-day rate? What must be the relationship between dollar

interest rates and pound sterling interest rates?

Answer: The fact that you are swapping into £5,000,000 at the 30-day rate forward rate

means that you are paying dollars and buying pounds. You would do this transaction at the

bank’s 30-day forward ask rate. To find the forward ask rate, you must realize that the 30–

Chapter 3: Forward Markets and Transaction Exchange Risk 5

b. Suppose you want to swap out of $10,000,000 and into yen for 2 months. What are the

cash flows associated with the swap?

Answer: When you swap out of $10,000,000 into yen in the spot market, you are selling

dollars to the bank. The bank buys dollars at its low bid rate of ¥98.75/$, so you get

c. If one of your corporate customers calls you and wants to buy pounds with

dollars in 6 months, what price would you quote?

Answer: If the customer wants to buy pounds with dollars, the customer must pay the

6. Intel is scheduled to receive a payment of ¥100,000,000 in 90 days from Sony in

connection with a shipment of computer chips that Sony is purchasing from Intel.

Suppose that the current exchange rate is ¥103/$, that analysts are forecasting that the

dollar will weaken by 1% over the next 90 days, and that the standard deviation of 90–

day forecasts of the percentage rate of depreciation of the dollar relative to the yen is

4%.

a. Provide a qualitative description of Intel’s transaction exchange risk.

b. If Intel chooses not to hedge its transaction exchange risk, what is Intel’s expected

dollar revenue?

Answer: If Intel chooses not to hedge, the expected dollar revenue is the expected dollar

Chapter 3: Forward Markets and Transaction Exchange Risk

6

c. If Intel does not hedge, what is the range of possible dollar revenues that

incorporates 95.45% of the possibilities?

Answer: We are told that the standard deviation of the rate of depreciation of the dollar is 4%.

The standard deviation of the future spot rate is therefore 4% of the current spot rate or 0.04



¥103/$ = ¥4.12/$. Thus, plus or minus 2 standard deviations around the conditional expected

future spot rate is ¥101.97/$ + ¥8.24/$ = ¥110.21/$

¥101.97/$ – ¥8.24/$ = ¥93.73/$

The range that encompasses 95.45% of possible future values for Intel’s receivable is therefore

¥100,000,000 / ¥110.21/$ = $907,359

¥100,000,000 / ¥93.73/$ = $1,066,894

7. Go to the Wall Street Journal’s Market Data Center and find New York closing prices for

currencies. Calculate the 180-day forward premium or discount on the dollar in terms of the

yen.

8. Go to the St. Louis Federal Reserve Bank’s data base, FRED, at

http://research.stlouisfed.org/fred2/ and download data for the exchange rate of the Brazilian

real vs. the U.S. dollar. Calculate the percentage changes over a one month interval. What loss

would you take if you owed BRL 1 million in one month and the dollar depreciated by two

standard deviations.

Answer: Data on FRED for the Brazilian real per dollar start in January 1995 until the present. Our

data ended with June 2017. Using the full sample available to us, the monthly standard deviation of