SWAP-

ARBITRAGE
Arbitrage in Spot Market

Bank A and B quote :-

A B
GBP /USD
1.4550/1.4560
1.4538/1.4548
Is there an Arbitrage opportunity?
YES: there an Arbitrage
opportunity
i.e Bank A
* *

Bank B *
*
Buy pound from B at 1.4548 and sell to
A at 1.4550.
How can the bank
remove the
Arbitrage
opportunity?
Bank will change quote to:-

A B
GBP /USD 1.4550/1.4560
1.4545/1.4555
e Bank A
* *

Bank B
* *
Buy pound from B at 1.4555 and sell
to A at 1.4550.Loss.No Arbitrage.
 SWAPS
Combination of two or more deals.
Spot and fwd simultaneously.
Spot 60 day dollar-euro swap is spot
purchase of dollar and fwd sell of the
same dollar.
Both are fwd then FWD – FWD.
Temp X of one currency for other,
With obligation to reverse deal for
other.
 SWAPS

Amount of base currency same.

Other currency rate in Fwd leg
different due to Premium or Discount.
Difference Swap Margin.
 SWAP MARGIN

USD/CHF-1.4265/1.4275.
1 MONTH SWAP-15/8.
Means 0.0015/0.0008,.must be added
to the Spot rates.
 CALCULATION

Actually the forward rate is

USD/CHF-1.4280/1.4283.
Less
Spot rate -1.4265/1.4275
We get the swap margin
- .0015/.0008
i.e.15/8.
 SWAP EXAMPLE

Bank monitor Swap Rates.

Temporary X of one currency for
another.
Manufacture Swap quote from Euro
rate and vice- a- versa.
 PROBLEM

Customer wants 3 month CHF-LIRA

Swap.
Customer will Sell CHF 1 million spot
against LIRA.
Buy CHF 1 million 3 month Fwd
(?)against LIRA.
Fwd market thin.
Bank will go to Euro-Lira market.
 SOLUTION

Euro-rates:-
CHF/ITL Spot- 755/765.
Euro CHF: 6 – 6 ¼.
Euro LIRA: 15 – 15 1/2.
What swap margin must the bank
quote?
 Assume Bank has given Swap rate as
CHF/ITL -760.00.
Bank borrows ITL 760 Million at 15 ½
and deliver customer.
Bank receives CHF 1 Million from
customer and invest in deposit at 6%.
At maturity after 3 month Bank must
pay:-
 ITL 760(1+ 0.25(0.1550))million=
ITL 789.45 million.
The CHF deposit would have grown to
CHF 1[1+0.25(0.06)]million=CHF 1.015
million.
The bank will break even if it charges
(789.45/1.015)=777.78 lira per CHF on the
fwd leg of the fwd contract(?).
The bank has thus manufactured a swap
quote from the inter bank deposit market.
 PROBLEM - 2

Customer wants 3 month Loan of DKK

50 Million.
No euro market.
Spot USD/DKK-8.5025/35.
3 –month Swap- 350/400.
Euro Dollar 3 month rates-8 ¼ -8 ¾.
What rate of interest should the bank
quote on the DKK loan?
 Solution
Suppose bank does Swap at spot rate
8.5030.
Swap Margin -400 pips.
Thus rate of fwd leg would be DKK 8.5430.
(8.5030 + .0400)
Bank has to borrow $ (50/8.5030)million to
buy and and loan DKK 50 million.
On maturity bank has to buy back same
amount of dollar @ DKK 8.5430.
It also has to pay on dollar loan :-
$(50/8.5030)[0.25(0.0875)]
Out right forward USD/DKK-8.5435.
Total amount to be recovered from
customer DKK:-
(50/8.5030)[8.5430+(0.25)(0.0875)
(8.5435)] million =DKK 51.3342.
i.e. 4*[(51.3342/50)-1]
=0.1067=10.67%
PROCESS
Bank to borrow $ equivalent to 1 mln DKK.
Use spot leg of Swap to convert to DKK.
Sell dollar at 8.5030 DKK for every 1 $.
This is also no of dollar required to be
borrowed.
Reverse Swap with fwd leg with buy of
dollar at 8.5430 DKK for every Dollar.
Go for outright Fwd to cover risk at
8.5435.Pay 8.5435 Dkk for every 1 dollar
after 3 month.