Currency Forwards
Are currency forwards priced solely by arbitrage? According the interest rate parity, forwards are priced by the formula below:
F = S * ((1+d)/(1+f))
where:
F = forward exchange rate (domestic over foreign)
S = the current spot exchange rate (domestic over foreign)
d = the domestic short term rate
f = the foreign short term rate
I'm curious if there are any supply-demand characteristics with pricing currency forwards. Are currency forwards the market's expectation for future currency exchange rates, or are they basically just a function of the current spot rate and interest rates?
Thanks for any insight
forwards are not the markets expectation of future spot rates at all, they are just the carry adjusted spot rate - these are NOT the same thing. Also it is important to realize that traders don't have a calculator where they input the domestic and foreign rates along with spot, hit calculate and come out with the forward price, rather the fwds are a traded instrument from which the rates are implied. It is more like "I know what my fed funds for this term is, I know at what rate the fwd is trading, so I can solve for my foreign rate"
A forward gives you a risk-neutral expected exchange rate at some point in the future. This works exactly the same way as futures pricing in any other mkt.
As to the not having a calculator, of course we gots a calculator for that. FXFA, it's called. The way you describe it, there's a bit of chicken an egg problem.
Forwards are a type of rate differentials determined by the market. That is ALL. Rates fool was right. Obviously there are subtleties though. You can see them as a "derivative" that allows you to modify the currency of an asset or a liability.
PS: I trade forwards at a BB.
Secondly, what precisely was I wrong about, in contrast to rates fool? Pls be specific...
As to you trading fwds at a BB, you have my sincerest congratulations.
What? Given the instantaneous rates curves (including funding) and the spot rate, the forward is absolutely the expectation of forward spot... that's a definition. Otherwise it would be arbable via carry. If you think there is some abberation due to funding requirements, then do the swap and take advantage.
I'm not sure what you're getting at. I mean I'd agree with you, but then we'd both be wrong.
PS: I trade options at a BB, and the underlying is the forward.
Currency forwards are not rate differentials or carry adjusted spot rate. You just need to chart the fucking things to see that...
Revsly, I don't trade currency options, just a bit of the underlying, interested to hear your take on this example. Did you read chapter 1 of HF market wizards by any chance - Colm O Shea talks about the carry of the underlying currency paying for your theta? So when you own a call to buy higher yielding currency in the future vs USD, every day that spot stays the same and does not depreciate vs $ (as covered IR arbitrage would imply) then you more are in the money by (forwardpoints/datefraction) because the strike is @ the fwd. FX carry (owning spot HY and lending them overnight every day vs USD) is a strategy that has consistently performed, this shouldn't work if fwds are the markets expectation of spot. How do you feel about that?
The way I understand it (and it sounds like others who trade this stuff do) is that the fwd is where you can do the trade for future settlement, today. You can infer via a no arbitrage argument various rates in USD or domestic (in reality neither will be observable anywhere else in the market, other than in basis) that reflect the amalgamated effects of a) policy/MM rates and b) actual funding demand for each currency. Good example is that in stressed times, people want USD so the implied USD rate goes up (regardless of what FF does), because when people agree a trade to buy $ now vs foreign and sell $ fwd vs foreign (in effect they are borrowing dollars for term), they are prepared to sell the $ fwd cheaper in order to get the $ in today for their funding needs. This then goes into the parity equation and via "oh look $ is cheaper in the future so the $ rates must be higher" when in fact this is a funding requirement effect, not an interest rate effect, and certainly not an implication that $ will depreciate in the future.
I guess FX points are tiny and relatively static vs the actual spot rate and movement in spot so it makes sense to approximate them as the delta hedges for options, especially as they are very very liquid!
I am by no means an expert, and am very very tired, so please tear this to shreds/discuss/etc - clearly there is non consensus so it would be good to thrash it out! :D
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