Confusion of Currency Forward in Schweser Notes

I saw a question from another forum and I think this is worthy to discuss here and hope it will help.

In Schweser Note Level 1 Book 5 2009 page 172, an investor enters into currency forward so that he can exchange 50M Euro for USD at USD1.23 per Euro in the future. At settlement, the price is actually USD1.25 per Euro. The answer is that the investor has to pay USD 1M to the counterpart.

The confusion is why the investor who is longing USD has to pay? I suggest treating any forward problem in this way:

1)      First you have to make sure if the investor is longing or shorting USD? It is longing. The reason he entered into contract is that he expects USD to appreciate. If USD appreciate, then he will receive less USD in the future (e.g. if it becomes USD1.1 per Euro). That’s why he enters the contract to make sure he will receive USD1.23 per Euro. Should he have expected USD to depreciate, he won’t have entered a contract because he will expect to receive more USD (e.g. USD1.3/Euro) in the future.

2)      Now we know he’s longing. Then just like any other investment, he will lose money if USD actually depreciates! And indeed this is the case. Losing money means that he has to pay his counterpart by (50M * (1.25-1.23) = USD 1M)

Though my wording is long but the logic is simple. In the stressful exam, this is the best way to help you get the right answer!

Now we go back to the contract itself and do an actual transaction. On the settlement day, with 50M Euro, the investor can change for 50M*1.25 = USD 62.5M in the free market. So, he can just break the contract which will only give him 50M*1.23 = 61.5M. But for his counterpart, he’s expecting to give the investor USD 61.5M and then exchange the 50M Euro for USD 62.5M in the free market. So you can see what will happen if the contract is not observed: The investor earns USD 1M and the counterpart loses the expected USD1M. There is no free lunch of course! So the investor has to pay 1M to counterparty to make him happy to concern the contract.

Hope that helps!!!