Week3_SP16 (2).pdf - Week 3 Forward contracts and...

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Week 3 Forward contracts and International money markets FIN 551
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Outright forward contracts Agreement now to buy/sell specified quantity of foreign currency at specified future date (maturity date) for specified price (outright forward price) Price is agreed now but No cash flows now Cash flows only at maturity
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Forward price quotes Outright forward price Forward premium/discount Subtract forward premium from spot (big/small) Add forward discount to spot (small/big) Annualized swap rate
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Forward price determination Covered interest parity – investments with equal risk must earn equal return Lend 1 domestic currency unit for N days at i $ Lend foreign currency: buy spot FC at S, lend for N days at i F , sell forward for N days maturity at F N
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Covered Interest parity If these two choices have same risk, F N / S = ( 1 + i F (N/360) )/( 1 + i $ (N/360) ) Or, annualized swap rate ( S - F N )/S x (360/N) ~ i $ - i F
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Covered Interest Arbitrage What forces make outright forward price behave in this way?
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