B481/S98/NOTES/Grabbe-5 FORWARDS, SWAPS, AND INTEREST ...

The quoted DM2.4273/90 is equivalent to DM2.4273-2.4290/US$, and the
30/20 is simply the amounts to be subtracted from 2.4273 and 2.4290,
respectively.
Question -- How did we know to subtract See page 105 for the rule:
(form 1) spreads always get bigger
(form 2) for a/b, if a > b, then subtract; if a < b, then add.
Clearly, form 2 is the easier to remember. But it is ad hoc; so you should
understand the logic behind firm 1.
Example 5.1
Suppose the spot rate is DM2.5005/10 per US$ and the one-month forward
margins are 100/95. Find the one-month outright forward rates.
Since 100 > 95, i.e., we have the a > b case. Therefore, we subtract.
The spot bid-asked is DM2.5005 - 2.5010 and the forward margin is
100/95. Thus, the one-month forward bid/asked is DM2.4905 - 2.4915,
which would be quoted as DM2.4905/10. Note that since the forward rate
ius lower than the spot rate, the DM is at a premium against the US$.
Suppose, however, the one-month forward margins are quoted as 95/100
and the spot rates are as given above. Find the one-month outright
forward rates.
Now we have 95 < 100, i.e., we have the a < b case. Therefore, we
add. The spot bid-asked is DM2.5005 - 2.5010 and the forward margin is
95/100. Adding, we have the one-month forward bid/asked as DM2.5100 -
2.5110, which would be quoted as DM2.5100/10.
INTEREST PARITY
This section starts out in exactly the right direction. The issue is Where
do premiums and discounts come from The answer is interest rates, and
the relationship between forward rates, spot rates, and interest rates is
called interest parity. Actually, there are two such conditions, one riskfree,
called ‘covered’, and the other risky, called ‘uncovered’. The
equations are easy to derive, since they result from an arbitrage
condition.
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