Hi,I was in some discussions recently and the topic of managing a forward book was briefly touched upon. Someone mentioned that a dealer typically manages forward position not by hedging with another forward, but instead manages the 'spot' risk, and the interest rate risk.I was wondering if someone could explain how thes risks are decomposed and hedged in practice e.g. what instuments, strategies etc. Is this also normal practice for managing a forward book?Cheers,Donal

forward fx rate = spot + interest rate differential. you can decompose this into a borrowing in one country versus lending in another. you hedge you rate risk using swaps, FRAs futures etc. make sure you dont get arbed.

DaveCould you be a bit more specific? Are you optimizing the Interest Rate Parity equation? Or is there some other relationship? What is the "delta netural" equivalent in this market?

its quite straightforward. if you short EURUSD in the spot market, then you have an exposure that you can only cover by buying back the EURUSD. if you do this in the forward market, then you hedge you f/x exposure buying buying EURUSD. to this you borrow $ and buy Euro. however there is an interest rate differential between $ and EUR and this affects the price of the forward rate. as a bookrunner its up to you to decide how you hedge the book - u could just buy back the forward or hedge the spot risk and rate risk.

Thanks Dave, much appreciated.Cheers,Donal

How would you price a vry basic instrument eg 3month Euribor vs 3Month Libor USD for a period of 3month starting spot? (consider spread on EUR leg)Very easy structure with exchange of nominal at start and end and one flow of interet on each leg..however comes 2 questions to my mind : 1-how do you determine the spread on EUR leg and what discount curve you use to come up with this spread?2-How does a USD libor fixing surprise (for example well below expectation fixing) impact this xccy basis swap that constitutethe first building block of every other xccy EURUSD basis swap?Thank you so much for your help!!

Well pre-Libor/Euribor fixing that is equivalent to a 3m FX Swap plus a 0x3 FRA out of Today in both USD and EUR. Post-fixing it is just a 3m FX swap. So the answers to your question would be:1) the spread is equal to the difference of the implied EUR interest rates from the FX Swap, feeding in the USD and EUR FRA prices, prior to the fixing, and post-fixing, it is the difference between that implied EUR rate and the Euribor fixing, feeding in the Libor fixing. As the notionals have to be funded in the overnight FX Forward market you work out whatever USD funding you are getting (Fed Funds or whatever - see numerous discussions on Wilmott about this) and then use the market FX Swap prices in order to construct a EUR discount curve.2) As you point out, this is a basic building block of longer-tenor xccy basis swaps. A USD libor fixing surprise can effect this in terms of making short-term (sub-3m) USD rates move higher/lower (if the rate fixed higher than expected and the market worried about a squeeze on USD funding, it is likely that these sub-3m rates would move higher), but you have been "fixed" into the 3m FX Swap at a rate implied by where the fixings were plus the spread on the EUR leg. There is thus interest rate risk on the two currency legs and in the time it takes to do an offsetting 3m FX Swap to roll the notionals to the date of the next reset, you are exposed to market moves.