Question

You are a foreign exchange dealer. You see the following quote on your Bloomberg screen:

a. The spot exchange rate of the Swedish krona is equal to 5.7 SKr per U.S. dollar. The three-month interest rates are 12% in SKr and 8% in dollars. What is the three-month forward exchange rate that you should quote? Please discuss what that means. Hint: calculate the rate, show calculation, briefly explain your answer.

b. In the language of currency traders would the Swedish krona be considered as “strong” or “weak” relative to the U.S. dollar? Please briefly explain your answer. Hint: Compare the $ to the krona and explain what it means.

c. Compute the annualized discount or premium on the dollar relative to the krona. Please briefly explain your answer.

d. After a careful look at your screen, you discover that the spot exchange rate is really 5.7000–5.7015. The 12-month interest rates are 121/4  1/2% in SKr and 81/4  1/2% in U.S. dollars. What should be the bid–ask quote on the one-year forward SKr/$ rate? Please briefly explain your answer.

Answer 1

a. Three month forward exchange rate =

F = 5.7 (1+12/4%) (1+8/4%) = 5.7559 SKr/$

It means that the exchange rate at which the bank agrees to exchange SKr for $, 3 months from now when it enters into a forward contract with us is 5.7559 SKr/$

b. The Dollar is considered as "STRONG" relative to the Swedish Krona because its forward value is higher than its spot value (5.7559 > 5.7000). Conversely, the Swedish Krona is considered as "WEAK" relative to the dollar.

c. The Dollar is at a premium compared to Krona as discussed above.

Annualised Premium = [(Forward Rate - Spot Rate) Spot Rate] * 12No. of months Forward

= [(5.7559 - 5.7000) 5.7000] * 123 * 100 = 3.9228 %

d. The bid-ask quote for one-year forward :

Bid Rate = 5.7000 (1+12.25%)(1+8.50%) = SKr/$ 5.8970

Ask Rate = 5.7015 (1+12.50%)(1+8.25%) = SKr/$ 5.9253