The creation of a forward exchange market can be a major business goal per se, or it may be a necessity generated by the desire to service a customer in a market where a forward exchange arket does not exist. In any event, this situation appears often in the case of currencies with very thin exchange markets, currencies which are not traded actively.
GIVING A QUOTE
To find what the quote for forward rates should be in the absence of a forward exchange market, the funds manager can use the money market rates for the two currencies involved. We know that the forward market should reflect the net accessible interest differential between the two currencies.
Let’s assume we have received a request for a quote of forward rates in a currency where a forward market does not exist at the time, say, the Mexican peso. The rate scenario is presented in Exhibit 8.11. A trader who is asked to quote forward rates must be willing to deal at the quoted rates. Our assumption is that the trader does not wish to assume a net exchange position. Therefore, if a transaction takes place at the quoted prices, the trader will want to get out of the outright forward net exchange position, as in the situation described in the preceding subsection “Getting Out of an Exchange Position.” Knowing the steps which the trader must take to get out of the currency trading outright forward position, we can estimate the costs or earnings involved in closing that position. These costs or earnings can then be used to calculate the forward rate.
In the previous case, we saw that to get out of an outright forward position, a swap position is created by dealing in the spot market after the net forward position develops. Then, to square the cash flows in the swap position, we could act in either the foreign exchange market or the money market. Since, in this case, there is not a forward market in existence; we are forced to use the money market to square the cash flow position.
More specifically, the steps to estimate the rates at which the forex trader would be willing to quote in the forward market are these:
1.Do in the spot market the opposite of what is done in the forward market. If a transaction takes place at the quoted price, a net outright forward position will be created. By doing the opposite in the spot market, the net exchange position is brought down to zero, and, instead, a swap position is created.
2.Square the cash-flow position (swap position) created by the spot transaction by using the money market (that is, borrowing the currency sold spot, investing the currency purchased spot) for a maturity to match the value date of the forward transaction.
3.Compute the interest differential resulting from the two money market transactions and convert it into a swap rate.
4.Obtain the desired forward quote by adding or subtracting the swap rate from the spot rate used in the initial spot transaction.
To determine the three-month forward bid rate of dollars against Mexican pesos, using Mexican terms and assuming we deal at other people’s rates, we follow the steps indicated above:
1.We want a quote that gives the rate at which we are willing to buy forward dollars against pesos. Doing the opposite in the spot market means selling dollars against pesos. Since we are dealing at other people’s rates, this is done at the rate at which the market purchases dollars against pesos Mex$ 12.4900/$.
2.Now we have an outflow in dollars and an inflow in pesos spot. To square the cash-flow position, we do the following: (1) borrow dollars at 7.25 percent for three months and (2) invest pesos at 10 percent for three months. Again, we use the market’s rates.