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why is it for forward rate it is multiplied by higher rate when its usually lower rate when it is a payment and it is divided?
The exchange rates are quoted as $’s per €. Therefore in order to convert the €’s into $’s we multiply by the rate, and because it is a payment we use the higher rate.
Hi John I have a question here.
In scenario 1 of this question the spot rate has changed from 1·1497 to 1·1534 but the future price in a opposite direction 1·1560 to 1·1552. This essentially undermines the effort of hedging since this reduction results in a loss on futures, on top of a higher spot rate.
I feel this is contradicting the basic concept of hedging and usually if the spot rate goes up shouldn’t the currency future price go up as well although not in a linear manner?I know that it looks strange, but it is true here and is due to the change in the basis.
Currently the spot is 1.1497 and the futures price is 1.1560. So the basis is 0.0063, and the spot is lower than the futures price.
As time passes and the prices change, the spot here should always be lower than the futures price but the basis should fall linearly to 0.0018. So in scenario 1, if the futures price falls to 1.1552, the spot should change to 1.1552 – 0.0018 = 1.1534.
These are the same as the figures given in the scenario, and so in that scenario the basis will be falling linearly and using futures would result in a lock-in rate of 1.1542 as per the answer.
In scenario 2, the difference between the spot and the futures price does not turn out to be 0.0018. This means that the basis is not falling linearly as we usually assume and therefore the lock-in rate is not 1.1542.
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