In the ‘Executing a hedge’ example:
To close out the current hedge:
Hedge 1: uses the mid-market spot rate for JPY/HKD of 10.81.
Hedge 2: uses the bid spot rate for HKD/EUR of 10.02.
Why is one mid market-spot and one bid spot used to close out a current swap? It doesn’t seem consistent to me. Thanks!
The first hedge is a matched hedge (as in the initial amount is the same as the selling forward amount) – use mid-market spot rate.
The second hedge is a mismatched hedge (initial amount is different from the actual selling forward due to increased value in foreign investment) – use bid (or ask for buying forward).
The reason behind that is, when you first purchase JPY 800m @ Ask rate, you sell a forward JPY 800m @ Bid rate, hence you should use mid-market spot rate because both notional amount are the same you’re able to take the mid rate.
When you first buy EUR 8m @ Ask rate, you also sell forward EUR 8m @ Bid rate, and subsequently you sell additional EUR for the increased value in your foreign investment. Due to the difference in notional amount, you are not able to use the mid rate but the Bid rate for sell (Ask for buy) forward.
Also, p221 should explains further:
“The pricing of swaps will differ slightly depending on whether they are matched or mismatched swaps. If the amount of the base currency involved for the spot and forward legs of the swap are equal (a matched swap), then these are exactly offset- ting transactions; one is a buy, the other a sell, both are for the same amount, and a common spot exchange rate is typically applied to both legs of the swap transaction. Because the client is not being charged a bid–offer spread on the spot rate, it is standard practice to use the mid-market spot exchange rate for the swap transaction.”
Hope that helps.
@alta12, I also did not get what is the reason. The only difference I see is that, in the first case we cannot directly sell JPY, so we buy HKD. In the second case it was a direct one.
I think for the exam it may not matter whether we use the mid quote or the bid/ask quote.
@vincentt your views please. Not sure if we are missing some concept here.
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