Reading 54: Pricing and Valuation of Forward Contracts free, understand, confusion, represent

ajpheif16

Guys, I need some help on this topic too, on reading 54 Example 5:
my confusion:
1. what does $1.76/1.062 represent? I understand foward rate= $1.76/1.062*1.051=$1.7418, but what does $1.76/1.062 represent?
2. “Use it to buy 1/1.062= 0.9416 pounds”, what does this represent? use 1 pound devide by rate in UK risk free rate? what does this really mean?
CAN SOME ONE HELP ME PLZZZ?

Ionutzakis

First off, this is reading 48 in the new curriculum and the related page is 40.
1) 1.76 is spot rate is terms of USD while 1.062 represents the discount factor using the foreign currency’s interest rate. You can tell that 6.2% is the foreign rate because the spot rate is given in terms of USD. I know the USD is the domestic currency because the question states this!
2) This means you buy the foreign currency and invest it at the foreign interest rate. Think of it as buying a pound in Britain and depositing the pound in a bank in Britain. Since the interest rate is 6.2%, a year later, the pound will be worth 1.062. However, in the above example, since you’re an arbitrager, you’re only buying 0.9416 units of the pound.

redskins44

ha, my 2013 books haven’t arrived, I’m using the 2012 books, that’s why. but to my confusion 1, it says the current spot rate is $1.76. Why would you discount it by the foreign rate? doesn’t that mean you get last year rate if this logic apply?(discount current year with the foreign interest rate i meant)
for my confusion 2, i would say the same thing, if you get 1 pound and discount it with the rate, it would give you how much this 1 pound should have been worth last year…no?
I guess i’m just confused why would you discount the rate on the current spot rate. Please help! thanks so much

Zesty

As an arbitrager, you expect the interest rates to hold over the upcoming period. So think of it this way - you’re initiating transactions today and will close your positions in the next period. In the interim, you hope that the interest rates stay favorable to your position.
I think you’re just over-engineering the time value of money effects .