really confused about this question, please help

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zzz

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As part of a foreign exchange hedging strategy, a U.S. portfolio manager has shorted a forward contract on 1,000,000 EUR dominated in USD with a forward price of $1.8095/€. With 3 months remaining on the contract, the spot rate is now $1.8038/€, the US interest rate is 5.5% and the foreign interest rate is 5%. Determine the value of the credit risk.
I thought the forward price of $1.8095/€ is equivalent to a spot level of (1.8095/1.05^0.25)/(1/1.055^0.25)=1.8074
and the credit risk today should be 1.8074-1.8038=$0.0036/€
However the correct answer is 0.003509 and it has nothing to do with rounding unfortunately.
This was on Schweiser book 4 p111.
Please help! would be very appreciated.
 
you have to use the formula to value a fwd contract.
S0/ (1+f)^t - F/(1+d)^t
try that
 
could you possibly explain that? it is not very intuitive to me
or point me to where I should look/read?
Thanks a lot
 
Ah I think I get your formula now Sunman, forward could be worked out based on current spot and then the difference between new forward and old forward can be discounted back to now (3m discount), and it simplifies to your formula exactly.
Thanks a lot.
But I still don’t see the flaw in my original logic which is super annoying:(
 
yeah essentially its the Interest Rate parity formula rearranged. Idea is to discount the forward back to todays time and compare it to the spot rate. Just make sure you use the appropriate domestic and foreign interest rates.
 
zzz wrote:
Ah I think I get your formula now Sunman, forward could be worked out based on current spot and then the difference between new forward and old forward can be discounted back to now (3m discount), and it simplifies to your formula exactly.
Thanks a lot.
But I still don’t see the flaw in my original logic which is super annoying:(
Click to expand...
The only flaw in your original logic is you are not discounting the difference you calculated of .0036 to present day value. When you use interest rate parity you are comparing the future value to another future value.
 
However I used the spot rate - spot equivalent of the old forward rate (using IRP). So the difference is the present day value and didn’t require further discounting.
or I’m thinking about this completely the wrong way
 
You’re discounting the forward price in your formula using the foreign and the spot using the domestic. Should be the other way around.
Write out the interest rate parity formula and rearrange and you should get Spot/1+f - Fwd/ 1+d
 
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