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END OF CHAPTER EXERCISES - ANSWERS

Chapter 18 : Spot and Forward Markets

Q1 You are a market maker (dealer) and the spot rates you are quoting are
1.6000/1.6010 ($ per £). Explain how you can make a profit on a ‘round-trip’ of ‘buy-
sell’.

A1
As a market maker you would:
Sell £1 and receive $1.6010 (offer) and then buy £1 and pay out $1.6000 (bid)
You have made a net gain of 10 ticks/points per £1 ‘round trip.

Q2 What are the key differences between the spot and forward FX markets? Can you
use both for speculation ?

A3
The spot market is for “immediate” delivery although in practice a deal done today will
normally be settled after two working days. In a forward deal you agree the price today at
which you will exchange two currencies on a specific day in the future.

To use the spot market for speculation you “buy low and sell high” (or vice versa). Hence if
you thought the USD would appreciate in the future against the Euro, you would buy USDs
today at say 1.00 Euros per USD in the hope that you could sell them later for say 1.01 Euros
per USD, making a profit of 0.01 Euros (per $1 invested in the speculation).

Speculative profits in the forward market depend on the difference between the spot rate ST at
the maturity of the forward contract and the forward rate quoted at time t=0 (for delivery at
t=T). For example, suppose today you enter into a one-year forward contract to deliver $100
at F= 1.0020 Euros per USD. You do not pay any money today. If the spot rate in one years
time is ST = 1.00 Euros per USD then you make a speculative profit of 20 points. This is
because you can buy your $100 in the spot market at t=T for 100-Euros but when you deliver
the $100 against the forward contract you will receive 100.2 Euros. Your profit is €100 x (ST -
F) = 0.2 euros.

Q3 What are “forward points” ?

A3
Forward points are the difference between the current forward rate and the current spot rate.
Since there are different forward rates depending on the horizon (or maturity) of the forward
contract, there are forward points corresponding to these different forward rates.

Q4 Dealers are quoting the following rates for ‘cable’ (i.e. GBP/USD, ‘base/quoted’)

Dealer-A 1.5205/15
Dealer-B 1.5207/17
Dealer-C 1.5200/10
Dealer-D 1.5202/12

To which dealer would you sell GBP?

From which dealer would you buy GBP?

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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A4
Quotes are in $ per £. Sterling is the base (unit) currency.

You would sell sterling to the dealer who would gives you the most $’s. But the dealer who
buys sterling wants to give you ‘few’ dollars, that is the ‘left hand side’ (bid) figure applies.
You would therefore sell sterling to dealer-B and receive 1.5207 $ per £.

You wish to buy £1. The dealer when he sells £1 wants to receive as many USDs as
possible, hence the right hand side figure applies. You wish to buy sterling and pay as few
USDs as possible. These are 15,17,10,12 ticks for each of the dealers. You would therefore
buy sterling from dealer-C at 1.5210.

Q5 Given the following information :

Spot rate of US Dollar and Pound Sterling is 1.65 ($/£)
3 month UK interest rates are at 7.5% per annum (actual / 365, day count basis)
3 month US interest rates are 6% per annum (actual / 365 day count basis)

Assume there are 30 days in each month, then:

(a) Calculate the 30-day forward rate and the forward margin.
(b) Is sterling at a forward discount or forward premium ?

A5
Spot and forward rates are quoted as $-per-£, which we take to be “domestic per unit of
foreign”. Hence we take “domestic” = USA and “foreign” = UK

⎛ Days ⎞⎛ rUS ⎞ ⎛ 30 ⎞ ⎛ 6 ⎞
1+ ⎜ ⎟⎜ ⎟ 1+ ⎜ ⎟⎜ ⎟
⎝ 365 ⎠⎝ 100 ⎠ ⎝ 365⎠ ⎝ 100 ⎠
F =Sx = 1.65 x = 1.65 (0.9988) = 1.6480
⎛ Days ⎞⎛ rUK ⎞ ⎛ 30 ⎞ ⎛ 7.5 ⎞
1+ ⎜ ⎟⎜ ⎟ 1+ ⎜ ⎟⎜ ⎟
⎝ 365 ⎠⎝ 100 ⎠ ⎝ 365⎠ ⎝ 100 ⎠

Forward margin = forward rate - spot rate = 1.6480 - 1.6500 = -0.0020 (20 points)
(F – S) / S = - 0.12% over 30-days

rUK > rUS hence a US investor must get less USDs per £-sterling in the forward market, to
preserve CIP. Hence sterling is at a forward discount (and the USD at a forward premium).

Q6 A UK firm knows it will receive $10m in 1-years time (from the sale of goods in the
USA). Current interest rates are ruk = 10%, rus = 12% and the spot rate is S = 1.6
($/£).
(a.) Calculate the forward rate.
(b.) Explain how the UK could hedge this inflow $10m dollars in one years time
by using the money markets and the spot FX market (i.e. by not using the
forward market directly).

Hint : As the firm will receive $10m in 1-years time, get the firm to borrow the present
value of $10m from a US bank at the US interest rate, immediately switch this into
sterling at the spot rate and then lend at the sterling interest rate for 1-year.

A6
The no-arbitrage forward rate is F = S (1 + r$ ) /(1 + r£ ) = 1.62909
The UK firm will receive $10m in 1-years time. The UK firm can hedge this future cash inflow
using the money markets and the spot-FX rate b:

Today, the UK firm borrows the present value of $10m that is $8.92857m (= 10/1.12) from a
US bank.

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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It switches the $8.92857m into sterling and receives, today £5.58035m (=8.928/1.6)

It then lends the £5.58035m at ruk = 10%, which results in receipts of £6.13839m in one
years time

Hence the UK firm in 1 years time pays out $10m and receives £6.138m. Hence the implied
forward rate it has “manufactured” by using the money markets is 10/6.138 = 1.62909 $/£

Q7 What is the key difference between the uncovered interest parity (UIP) and the
covered interest parity (CIP) relationships?

A7
UIP and CIP are equilibrium conditions since they each set out a specific relationship
between a set of variables which must hold, so that investors have no incentive to switch their
funds between two countries. CIP involves an investment choice between the domestic and
foreign country which involves no (market) risk since any future foreign currency receipts are
fully hedged using the appropriate forward FX rate – this is riskless arbitrage.

In contrast UIP involves investors taking a gamble on what the spot exchange rate will be at
the end of the investment horizon. It is therefore risky arbitrage. UIP assumes investors are
risk neutral – although investors know that their investment is risky, nevertheless they totally
ignore it when making their by investment decisions and only the expected return from the
investment matters.

So the key difference is that CIP involves riskless arbitrage and UIP is risky arbitrage as it
requires a forecast of the future spot exchange rate.

Q8 Suppose that the 1-year spot interest rate in Euroland is r = 8% p.a. and in USA is r*
= 5% p.a. and (rather stupidly) FOREX dealers (who are risk neutral) expect the Euro-
USD exchange rate over the next year to remain unchanged. Assume uncovered
interest parity holds.
(a) What will happen to the spot exchange rate, today and why?
(b) At what point will the spot exchange rate stop rising or falling?
(c) What are the likely consequences for UK exports and imports in the short-
term and in the longer term?

A8
(a.) US speculators will want to invest in ‘Euroland’ because of the higher interest rates,
since the latter will also translate into higher expected US dollar payments at the end
of the year, if they believe the exchange rate will remain unchanged. However, as US
speculators purchase spot Euros (to invest in Euro-assets) then the Euro will
appreciate, because of this increased demand for Euros (and the selling of spot US
dollars).

(b.) The spot exchange rate for Euros will rise today until it is sufficiently high, so that US
speculators believe it will fall over the coming year by 3%. This is the uncovered
interest parity (UIP) relationship:

Interest differential in = expected depreciation of the Euro

favour of Euroland over the coming year

(c.) If the Euro appreciates today, then Euroland exports become less competitive and
imports into Euroland will become cheaper to Euroland residents (i.e. priced in
Euros). Hence, Euroland exports fall and Euroland residents switch from buying
domestic goods to buying more imports. A recession will ensue in Euroland. In the
long run (5 – 10 years) the recession in Euroland will cause Euro-prices to rise less
rapidly as the economy slows down and unemployment rises (this is known as the
Phillips curve). Eventually, slower growth and higher unemployment leads to lower

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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inflation in Euroland (relative to the US where prices will be rising faster owing to
more rapid growth due to higher exports from the US. Hence, eventually price
competitiveness will be restored (at the new ‘higher’ Euro exchange rate).

Q9 Assume inflation in “Euroland” is 5% p.a. and in the USA is 2% p.a. If purchasing

power parity PPP holds, what is the (approximate) expected percentage change in
the exchange rate of the Euro over the next year?

A9
PPP assumes prices will be equalized in a common currency. This implies:

% depreciation in Euro/USD exchange rate

= Euro inflation rate- US inflation rate = 5 - 2 = 3%

If PPP holds then the Euro will be expected to depreciate by 3% against the USD. This
depreciation if it ensues, will make Euroland exports more competitive. Hence, a US resident
will pay the same price in USD in one years time for a Sak’s hamper from New York (i.e. a
fixed basket of goods) as she would pay in USDs for an identical hamper from shops on the
Boulevard Hausman in Paris.

Q10 Why might the economy take a long time to achieve PPP ?

A10
If all goods are homogenous then consumers (or importers) would immediately know whether
foreign goods (e.g. oil from Saudi Arabia) expressed in the domestic currency (e.g. Pound
Sterling), equalled the price of similar domestically produced goods (e.g. British ‘North Sea’
oil). Some goods are fairly homogenous (e.g. oil, raw materials, agricultural produce) and
here PPP will hold almost continuously. However, for non-homogenous goods (e.g. machine
tools) a change in foreign prices (or the exchange rate) may take some time to be reflected in
the price of home-produced goods. This applies a fortiori if it is the ‘wage-price spiral’ that is
the mechanism whereby domestic prices respond to foreign prices. The latter mechanism is
relatively slow as it works through wages and the price of goods and services in various
sectors. For example, prices in the retail sector may not immediately adjust one-for-one with
any rise in the prices of agricultural products or raw materials.

Q11 The current exchange rate is 1.00 (Euros per $) and the price of Californian wine is
$10 (per bottle) and the price of Europlonk is € 10 (per bottle). The exchange rate
now moves to 0.9 Euros per dollar, but the local currency price of the Californian wine
and the Europlonk remain the same. What are the likely consequences for the US
economy and the Euroland economy?

A11
Initial prices of Californian wine are $10 or € 10. Similarly, initial prices of Europlonk are $10
or € 10. The devaluation of USD is from 1.0 to 0.9 Euros per $ implies the following prices:

USA resident Euroland resident

Price of Californian $10 €9
Price of Europlonk $11.11 € 10

California wine now sells for more Euros in Euroland while Europlonk sells less for less USD
in the USA. After the appreciation of the Euro (depreciation of the USD) Euroland is less
price competitive and this may lead to a fall in exports of Europlonk and hence a rise in
unemployment in Euroland (followed after some time, by lower Europlonk prices, in Euros).

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition