International Corporate Finance

The Foreign Exchange Market

Prof. dr. Kenneth De Beckker

2021 - 2022
Introduction
Foreign exchange rate risk – why it matters to companies
• Contractual exposure due to nominal exchange rate risk: Uncertainty about
the value of an asset or liability that expires at some future point in time and
is denominated in foreign currency.
• Example: Company imports raw material from India
=> costs of goods depend on the value of the Indian rupee relative to the home currency.
• Hedging: Use of financial instruments like forwards, futures, options or
swaps.

2 International Corporate Finance - The Foreign Exchange Market

The Foreign Exchange Market: Overview

3 International Corporate Finance - The Foreign Exchange Market

How Foreign Exchange Markets Work
International Financial Management Handbook
The Organization of the Foreign Exchange Market p.47-57
Schrimpf, A. and Sushko, V. (2019) Sizing up foreign exchange markets, BIS Quarterly
Review December 2019

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The structure of the ForEx market
ForEx (or FX) operates 24 hrs/day

• Interbank market
50% of transactions
Corporations – 7.5%
Other financial institutions – 92.5%
Most trades are $1M or more

• Retail market
Individual speculators
Tourists, travelers
Mainly trading through online brokers
Small amounts:
standard lot 100,000
mini lot 10,000

Source: Bekeart G. J. and R.J. Hodrick (2017). International Financial

5 International Corporate Finance - The Foreign Exchange Market
Management. Cambridge University Press
Geography

Benefits of a 24h market:

- React to opportunities whenever they

arise
- Trade when it’s most convenient
- Take advantage of periods of higher
volatility when markets overlap.

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Source: Bank for International Settlements – triennial FX survey 2019
Market size
• Global foreign exchange market turnover, 1995-2019 (Billions of USD)

7 Source: Bank for International Settlements – International Corporate Finance - The Foreign Exchange Market
triennial FX survey 2019
Market size
• Market turnover by currency pair (against USD)

8 Source: Bank for International Settlements – International Corporate Finance - The Foreign Exchange Market
triennial FX survey 2019
Market participants – interbank market
• Interbank market makers/dealers/liquidity providers
• Deutsche Bank, UBS, Citigroup, Bank of America, Goldman Sachs and HSBC
• They give two-way quotes binding up to an agreed limit (e.g USD 10m or 20m). Purely bilateral.
• They profit from buying foreign exchange at a bid price and reselling it at a slightly higher offer or
ask price. The difference between the bid and the ask is called the spread.

• Interbank forex brokers

• Intermediaries between interbank market makers.
• Usually by phone and a call box
• Brokers shop around to find takers of someone else’s offers

• Interbank Electronic forex brokers

• Electronic Broking Services (EBS) and Thomson Reuters Dealing service

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Market makers – example
• A German manufacturer needs to buy British pound to pay his U.K. supplier

€ 1.1007 per £ - € 1.1010 per £

BID ASK

Return
SPREAD
€0.0030 per £

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Market participants – interbank market
• Central banks
• Smaller financial institutions
• Clients of large market makers

• Hedge funds
• Multinational corporations
• Hedge the currency risk from operational
activities

• High net worth individuals

George Soros
Bill Lipschutz
The man who broke the Bank of England

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Transaction types
• Spot transaction:
• A spot transaction in the interbank market is the purchase of foreign
exchange, with delivery and payment to take place, normally, on the
second following business day (t+1 for US-Canada and US-Mexico).
• The date of settlement is referred to as the value date.
• In the retail market the spot transaction doesn’t involve necessarily a wait
of two days for settlement
• Notation spot exchange rate at time t: St

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Transaction types
• Forward transaction:

• A forward transaction requires delivery/payment at a future value date of a

specified amount of one currency for a specified amount of another
currency.

• The exchange rate is established at the time of the agreement, but

payment and delivery are not required until maturity.
• Nowadays up to ten years, but the most active forward markets remain “30”, “90” days
• Quote for any “broken” date on request
• Volume: larger than the spot market
• Notation forward rate at time t for delivery/payment at a future time T: Ft,T

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Transaction types
• Foreign currency swaps
• Foreign currency derivatives
• Forex options
• Forex futures

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Electronic ForEx trading

Source: Bank for International Settlements – triennial FX

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survey 2019
Settlement risk
International Financial Management Handbook
Cross-Currency Settlement (or Herstatt) Risk p.74-78
Kos D. and R.M. Levich (2016). Settlement risk in the global FX market: How much
remains? Available at SSRN: https://ssrn.com/abstract=2827530

16 International Corporate Finance - The Foreign Exchange Market

Settlement risk – Herstatt risk
• The risk that one side of a forex transaction is not delivered is settlement risk
or Herstatt risk
• Is especially relevant for forex transactions because these involve the
payment systems of two countries in different time zones.
• Banks are interconnected internationally
• Large turnover in ForEx markets
Settlement risk transforms into systemic risk

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Settlement risk – Herstatt risk

Conventional settlement of a foreign exchange transaction

Source: Mägerle J. and D. Maurer (2009). The Continuous Linked

18 Settlement foreign exchange settlement system (CLS). Swiss National International Corporate Finance - The Foreign Exchange Market
Bank Report – November 2009
Settlement risk – Herstatt risk
• Continuous Linked Settlement (CLS) Bank: international payment system for
the settlement of forex transactions
• Owned by 69 financial institutions
• Settles trades in 18 currencies
• Payment-versus-payment system: you get paid only if you pay
• Multilateral netting, decreases the total exposure

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Settlement risk – Herstatt risk

Settlement of a foreign exchange transaction in accordance with a

payment-versus-payment principle
Source: Mägerle J. and D. Maurer (2009). The Continuous Linked
20 Settlement foreign exchange settlement system (CLS). Swiss National International Corporate Finance - The Foreign Exchange Market
Bank Report – November 2009
Settlement risk – Herstatt risk

Source: Bekeart G. J. and R.J. Hodrick (2017).

21 International Financial Management. International Corporate Finance - The Foreign Exchange Market
Cambridge University Press
Settlement risk – Herstatt risk

Source: Bekeart G. J. and R.J. Hodrick (2017).

22 International Financial Management. International Corporate Finance - The Foreign Exchange Market
Cambridge University Press
Exchange Rate Quotations
International Financial Management Handbook
Currency quotes and prices p.57-72
Describing changes in exchange rates p. 78-83

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 Quoting conventions
• The HC/FC convention: the price in units of home currency
(HC), per unit of foreign currency (FC) – like we do for bread or
umbrellas.
• Example:
• “$1.15/€” is an American’s natural quote for the EUR. Under our
convention, Eurolanders would naturally quote € 0.87/$.
• “$ 0.7563/CAD” is an American’s natural quote for the CAD, since CAD
is the currency in the denominator, the one the price is expressed in.
• Semantics:
• Called “right” or “direct” quote;
• Denoted in the textbook as e.g. 𝑆𝑡 = CAD 1.2150/USD
where CAD/USD is the dimension.
• Pro’s use the inverse of the dimension as the symbol:
“USDCAD or USD/CAD = 1.2150” (dimension: CAD/USD)
“value of USD in CAD”
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Quoting conventions
• The FC/HC convention: “with one Rupee you can buy 1/15th of a bread” –
indirect quotation
• Who uses the weird FC/HC convention?
• against USD: NY traders
• Traders need a unique language
• Under the Bretton Woods system, European governments had officially fixed the rates
as e.g. DEM/USD 4, their natural quote.
• against GBP: all pro’s, US traders and all Brits (and similarly for ZAR, AUD,
NZD)
• The pound used to be intractably non-decimal (until 1967)
• The pound used to play the key role taken by USD after WW2
• US traders thus use the unnatural quote for e.g. CHF, but natural quote for GBP
• against EUR: everybody
• The “EUR” is used to be foreign, even for Eurolanders

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Quoting conventions
• What conventions are standard, in practice?

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Quoting conventions
• Practice: www.x-rates.com

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Currency nicknames

Greenback
Kiwi

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Currency pairs nicknames

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Bid and Ask Quotes
• You buy at (bank’s) Ask, you sell at (bank’s) Bid
• Bid-Ask spread: = Ask – Bid >= 0 (why >=0?)
• Equivalent commission = ½ spread:
• Example EUR USD = $1.2045/€ – $1.2047/€
• Buying (at 47) is like paying midpoint (46) + cost 1
• Selling (at 45) is like getting midpoint (46) – cost 1
• Determinants of bid-ask spread:
• Retail: spreads fall with order size
• Wholesale: spreads fall when risk of posting a quote is lower:
• High liquidity
• Low volatility
• A normal quantity – not too large

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Bid and Ask Quotes
• To get an idea of transaction costs in forex trading, bid-ask spreads are
expressed in percentage points:

𝑎𝑠𝑘 − 𝑏𝑖𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑠𝑝𝑟𝑒𝑎𝑑 =
𝑚𝑖𝑑𝑝𝑜𝑖𝑛𝑡
A treasurer of a U.S. company purchases pounds with dollars in anticipation
that the company will purchase some British goods.
Spot rate: $ 1.3240/£ - $1.3244/£

What is the percentage spread?

If the treasurer buys £ 1,000,000, what is the total transaction cost?

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Inverting bid and ask quotes
• Rule: 1/ask = bid, 1/bid = ask
• Why?
• mathematically, 1/bigger = smaller and vv
USD/GBP inverse = GBP/USD
bid = 1.3250 1/1.3250 = 0.7547 = ask
ask = 1.3255 1/1.3255 = 0.7544 = bid

• semantically, when one switches home currency, buying currency 1

becomes selling currency 2
• Mr X gives 1000 yen to the bank and receives 10 dollar
• to a Japanese this looks like buying USD 10 at JPY 100/USD
• to an American this looks like selling JPY 1000 at USD 0.01/JPY

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Currenex trading platform

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Currenex trading platform
Dimension is
Quote: USD/EUR
USD/EUR
1.4431-1.4432

Quantity offered, you Quantity asked, you

can sell 5 million can buy 1 million

Currenex trading platform - details

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Impact of speculators
• The foreign currency market is dominated by speculators
• Flash crash Australian dollar on January 2, 2019

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Measuring a change in exchange rates
• Measuring a change in the spot rate for quotations expressed in
home currency terms (only valid for direct quotation):
new rate - old rate
s=
old rate
• If s > 0 => the foreign currency has appreciated (in nominal terms)
• If s < 0 => the foreign currency has depreciated (in nominal terms)
• Example: HC/FC
• On June 30th 2018: € 0.8547/$
• On December 31st 2018: € 0.8754/$
0.8754−0.8547
• Percentage change in exchange rate: = 0.0242
0.8547
The dollar appreciated with 2.42% against the euro over a period of six months.

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Cross rates
• Exchange cross rates

Source: http://x-rates.com
dollar price of euros
• Sterling price of euros =
dollar price of sterling
𝑈𝑆𝐷 1.12401 /EUR
£ 0.876757/€ =
USD 1.29559 /GBP

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Forex Trading
International Financial Management Handbook
Triangular Arbitrage p. 63-66

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Arbitrage and Shopping around
• Arbitrage (two-way)
• Buy low, immediately re-sell high without risk
• Arb opp: no net investment, no chance of loss, and possibly a gain
• Too nice to be true: self-destructive
• Two-way trade: sum of transaction costs matters

• Shopping around (one-way)

• Exogenous motivation to do a particular trade – just choose in what market
segment you’ll do the trade
• Difference of costs matters
• Opportunities happen all the time – are often intended by market maker

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Arbitrage Across Market Makers
• Example: What would you do when seeing …
Bank X: USD/EUR xxx56 – 58
Bank Y: USD/EUR xxx52 – 54
• arb opp: sure gain without really needing cash
• triggers massive flows
=> no-arb condition: Bidi  Ask j i, j - no empty
space

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Shopping Around Across Market Markers
• Example: What would you do when seeing…
Bank X: USD/EUR xxx56 – 58
Bank Y: USD/EUR xxx57 – 59
• All buyers go to … and all sellers go to …
• This may be temporarily the idea – if bank X has a (delete
one) shortage/excess and Y a shortage/excess.
• But in the medium run X and Y’s positions must vary all the
time.
Who, amongst these, traders is
keen on buying?
keen on selling?
just twiddling thumbs?

Why do wannabuys move both quotes, not just the bid?

Why do wannasells move both quotes, not just the ask?

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Triangular Arbitrage
• Triangular? Relations between spot rates quoted in various currencies –
e.g. GBP/USD, JPY/USD, JPY/GBP.

• For either application, we need to know the “synthetic” (indirect) rate

JPY/GBP.
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Triangular Arbitrage
• Example
• Citibank: $ 1.2223/€
• Barclays: $ 1.8410/£
• Deutsche: € 1.5100/£
You are a U.S. trader and have $ 1 million as trading budget. How will you
profit from these quotes?

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Triangular Arbitrage
• Example
• Citibank: USD/EUR 1.2223
• Barclays: USD/GBP 1.8410
• Deutsche: EUR/GBP 1.5100
The cross rate between Citibank and Barclays is:
1.8410 USD / GBP
= 1.5062 EUR/GBP
1.2223 USD / EUR
Cross rate < direct quote Deutsche
• Shopping around:
All GBP buyers go to Citibank and Barclays
All GBP sellers go to Deutsche

44 Arbitrage and shopping around

International Corporate Finance - The Foreign Exchange Market
Triangular Arbitrage

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Forward Contracts
International Financial Management Handbook
The Forward Foreign Exchange Market p. 105-114
Forward Premiums and Discounts p. 115-117

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Forward Rates
• Forward rates in pips:
1 Month 3 Months 6 Months 12 Months Spot rate

USD/EUR 192 192.8 588.2 590.7 1150 1156 2296 2310 1.2970

AUD/EUR 460 466 1280 1300 2390 2420 4640 4680 1.4302

JPY/EUR -291 -288 -891 -886 -1770 -1760 -3700 -3660 129.2664

• Note how swap spreads widen the forward spread:

47 Source: Sercu P. (2009). International Finance. International Corporate Finance - The Foreign Exchange Market
Princeton University Press
Forward Rates
• Imperfect Exchange Markets:
• The forward spread is always larger than the spot spread, and increases
with the time to maturity.
• Why?
• Interaction between default and bank’s worst possible loss:
• Probability of default is higher for larger maturities
• Worst possible loss to the bank, given default is higher for larger maturities
• Depth of market: liquidity in forward markets is lower than in spot markets.

48 Source: Sercu P. (2009). International Finance. International Corporate Finance - The Foreign Exchange Market
Princeton University Press
Forward premium and discount
• Forward premium/discount in percent per annum:

forward − spot 360

f = 
spot n
With n representing the number of days in the forward contract.

• If f > 0, the foreign currency is trading at a premium relative to the

home currency
• If f < 0, the foreign currency is trading at a discount relative to the
home currency

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Forward premium and discount
JPY/USD USD/GBP
Spot 129.87 1.4484
1 month 129.68 1.4459
6 months 128.53 1.4327

• The 6-month US dollar is trading at a forward _________ of

approximately ______ % per annum, relative to the Japanese yen.

• The 1-month British pound is trading at a forward _________ of

approximately ______ % per annum.

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Forward premium and discount
• The forward rate is the certainty equivalent of the future spot rate:

𝐹𝑡,𝑇 = 𝐶𝐸𝑄𝑇 𝑆ሚ𝑇

• The certainty equivalent is the risk-free amount that, to the market, is

equivalent to the risky 𝑆ሚ𝑇 .
• If the foreign currency trades at a forward premium (discount):
• The market expects that the currency will appreciate (depreciate) in the
future.

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Market value of a forward contract
• A forward contract has two legs, each of which can be thought of as a
promissory note:
• Asset: you receive a PN from the bank ad FC1
• Liability: you write a PN to the bank ad HC
• So the contract’s value is equal to the net value of this small portfolio.

Source: Sercu P. (2009). International Finance.

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Princeton University Press
Market value of a forward contract
• A forward contract has two legs, each of which can be thought of as a
promissory note:
Notation:
• Asset: you receive a PN from the bank ad
r represents theFC1
de-
annualized rate of return at
• Liability: you write a PN to the bank home
ad HC
• So the contract’s value is equal tor*the net value
represents of this small portfolio.
the de-
annualized rate of return
abroad.

Source: Sercu P. (2009). International Finance.

53 International Corporate Finance - The Foreign Exchange Market
Princeton University Press
Market value of a forward contract
• Generalisation:
• Market value at t, of forward purchase signed at 𝐹𝑡0,𝑇 :
1 Ft 0,T
 St −
1 + rt ,T
*
1 + rt ,T

Translated value of FC PV of HC liability

asset

• Market value at t, of forward sale signed at 𝐹𝑡0,𝑇 :

Ft 0,T 1
−  St
1 + rt ,T 1 + rt ,T
*

PV of HC asset Translated value of FC liability

Source: Sercu P. (2009). International Finance.

54 International Corporate Finance - The Foreign Exchange Market
Princeton University Press
Market value of a forward contract
• PV is just the PV of 𝐹𝑡,𝑇 − 𝐹𝑡0,𝑇 , the locked-in “gain (+/-) from a
reverse purchase:

𝐹𝑡,𝑇 −𝐹𝑡0,𝑇
• Market value forward purchase at 𝐹𝑡0,𝑇 :
1+𝑟𝑡,𝑡

Source: Sercu P. (2009). International Finance.

55 International Corporate Finance - The Foreign Exchange Market
Princeton University Press
Implication 1: Value at Maturity
• If t = T, then rT,T = … = r*T,T = 0, then:
forward purchase: forward sale:
ST Ft 0,T Ft 0,T ST
− = ST − Ft 0,T − = Ft 0,T − ST
1 + rT ,T 1 + rT ,T
*
1 + rT ,T 1 + rT*,T

56 Source: Sercu P. (2009). International Finance. Princeton International Corporate Finance - The Foreign Exchange Market
University Press
Implication 2: Value at Inception
• If 𝑡0 = 𝑡 , then
forward purchase: forward sale:
St Ft 0,t Ft 0,t St
− =0 − =0
1 + rt ,t 1 + rt ,t
*
1 + rt ,t 1 + rt ,t
*

• Notes:
• Holds only at the moment the contract is signed – otherwise the contract
would be pointless.
• The forward rate is the certainty equivalent of the future spot rate:
Ft ,T = CEQt ( ST )
The CEQ is the certain (risk-free) amount that, to the market is
equivalent to the risky 𝑆ሚ𝑇 .
Source: Sercu P. (2009). International
57 International Corporate Finance - The Foreign Exchange Market
Finance. Princeton University Press
Market value of a forward contract
• Generalisation (with N = size of the forward contract, in foreign currency units):
1. The contract is at inception
 Value is equal to ZERO.
2. The contract is at maturity
 Value is equal to 𝑆𝑇 − 𝐹𝑡,𝑇 × 𝑁 in case of a forward purchase of foreign ccy
 Value is equal to 𝐹𝑡,𝑇 − 𝑆𝑇 × 𝑁 in case of a forward sale of foreign ccy
3. The maturity of the contract is not reached yet
𝑆𝑇 𝐹𝑡0,𝑇
 Value is ∗ − × 𝑁 in case of a forward puchase of foreign ccy
1+𝑟𝑡,𝑇 1+𝑟𝑡,𝑇
𝐹𝑡0,𝑇 𝑆𝑇
 Value is − ∗ × 𝑁 in case of a forward sale of foreign ccy
1+𝑟𝑡,𝑇 1+𝑟𝑡,𝑇

Source: Sercu P. (2009). International

58 International Corporate Finance - The Foreign Exchange Market
Finance. Princeton University Press
Market value of a forward contract
• Example:
• Some time ago, you bought forward 1,500,000 British
pounds (GBP) against euro (EUR) at a forward rate of
EUR 1.16/GBP. The contract expires in three months
(90 days).
• Currently, the spot rate is equal to EUR 1.20/GBP.
The risk free rates are equal to 4% per year in Europe
and 3% per year in the U.K.
• The market value of this forward contract is:
 
St Ft 0,T  EUR/GBP 1.20 EUR/GBP 1.16 
− = −   GBP 1500000
(1 + r *t ,T ) (1 + rt ,T )  1 + 0.03   0.04  
1 + 
  4   4  
= EUR 63,828
59 International Corporate Finance - The Foreign Exchange Market
What have we learned in this chapter?
• Exchange rates, in this course, are always shown as HC/FC. Market markers
quote them as bid-ask, with the spread determined by risk considerations.
• The market is traditionally a bilateral OTC market (“conversations”), but is now
becoming more multilateral (Reuters 3000 and EBS auctions).
• There are spot and forward segments.
• Forward quotes can be outright or in swap-rate format.
• Even in purely bilateral markets, prices are (imperfectly) unified across market
makers by arbitrage and by shopping around. True, traders often skew their bids
– just until their desired trade has been achieved.

60 International Corporate Finance - The Foreign Exchange Market

What have we learned in this chapter?
• Viewing an outstanding contract as a portfolio of two PNs, one long and one
short, we can easily value an outstanding forward contract at any time 𝑡 as:
𝑆 𝐹
• Forward purchase: 𝑃𝑉 𝑆ሚ𝑇 − 𝐹𝑡0,𝑇 = 𝑡∗ − 𝑡0,𝑇
1+𝑟𝑡,𝑇 1+𝑟𝑡,𝑇

𝑆𝑡 𝐹𝑡0,𝑇
• Forward sale: 𝑃𝑉 𝐹𝑡0,𝑇 − 𝑆ሚ𝑇 = ∗ −
1+𝑟𝑡,𝑇 1+𝑟𝑡,𝑇

which simplifies to 𝑆𝑇 − 𝐹𝑡0,𝑇 or 𝐹𝑡0,𝑇 − 𝑆𝑇 when 𝑡 = 𝑇 and to zero when 𝑡 = 𝑡0

• The forward rate is also a risk-adjusted expectation, or certainty equivalent.

61 International Corporate Finance - The Foreign Exchange Market