Question

Agnetha Poulsen works as an analyst in the foreign exchange overlay strategies department for CFN, a large asset management firm serving institutional clients. She is concerned about the excessive unhedged currency exposure taken on by the overlay strategies department. She makes an appointment with Alvilda Kristensen, director of risk management, to discuss this matter. Prior to the

meeting, Poulsen collects information on foreign currency quotes and on interest rates as shown in Exhibits 1 and 2.

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Exhibit 1: Current Spot and Forward Exchange Rate Quotes

Quotes USD/CHF USD/EUR

Spot 0.9817/0.9821 1.2235/1.2238

30-day forward –7.6/–6.9 –7.21/–6.80

60-day forward –15.3/–13.3 –14.56/–13.76

90-day forward –24.3/–23.05 –23.84/–22.77

Exhibit 2: Selected Interest Rates

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Interest Rates USD EUR CHF

30-day rate 0.20% 0.91% 1.13%

60-day rate 0.21% 0.93% 1.15%

90-day rate 0.26% 1.04% 1.25%

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Poulsen also reviews the current open forward contracts. As an example, she reviews two contracts. Contract FX2001 is a 90-day forward contract initiated 60 days ago. The contract calls for purchase of CHF 200 million at an all-in rate of USD 0.9832. Contract FX2051 is a 90-day contract initiated 30 days

ago to purchase 100 million EUR at an all-in rate of 1.2242.

During her meeting with Kristensen, Poulsen expresses concern about traders establishing FX carry trades in several emerging market currencies. Kristensen assures Poulsen that CFN has adequate monitoring mechanisms. She continues that these carry trades have been generating significant positive returns for the clients and Poulsen should not worry about it. Kristensen further mentions that

the firm’s monitoring mechanisms trigger the sale of funding currency whenever volatility levels, implied by options on the investment currency, increase beyond a predetermined threshold.

What is the current mark-to-market value of the forward contract FX2051 in USD?

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Answer 1

Let's examine the forward contract FX2051 first.

Contract FX2051 is a 90-day contract initiated 30 days ago to purchase 100 million EUR at an all-in rate of 1.2242.

It's a 90 day contract initiated 30 days ago. The contract has now 90 - 30 = 60 days left for expiry.

Under this contract, we will be obligated to buy 100 million EUR after 60 days from now.

Now, look for 60 days forward contract to sell EUR. Look at the bid price

USD / EUR 60 days forward rate = Spot rate adjusted for spread = 1.2235 - 14.56 per 10,000 = 1.2235 - 14.56 / 10,000 = 1.222044

(Please note per 10,000 in above calculation is one hundredth part of 1% = 1/100 x 1% = 1/10,000)

Our obligation is to buy at an all-in rate of 1.2242

Hence, the mark to market Value in USD will be given by

$=\frac{(F_{t}-F_{0})\times Exposure}{1+R\times \frac{N}{360}}$

Where F_t = Forward rate today = 1.222044 (as calculated above)

F₀ = Forward rate on the contract

Exposure = EUR 100 mn = 100,000,000

R = 60 day USD interest rate = 0.21% = 0.0021

N = days left to maturity or expiry = 60

Hence, mark to market value in USD

$=\frac{(1.222044-1.2242)\times 100,000,000}{1+0.0021\times \frac{60}{360}}$

=  - $ 215,524.57