International Finance

Set – 5
Forwards, Swaps and Interest parity
P C Narayan
Reading: Reading:

PGA Ch 8



6 >>>> (next slide) IIMB/ PCN/ INT FIN/ L05 2 . the forward rate discount or premium for the foreign currency.Interest Rates and Exchange Rates •  The theory of Interest Rate Parity (IRP) provides the linkage between the foreign exchange markets and the international money markets. except for transaction costs. •  See Exhibit 7. •  The theory states: The difference in the national interest rates for securities of similar risk and maturity should be equal to. but opposite in sign to.

6 Interest Rate Parity (IRP) IIMB/ PCN/ INT FIN/ L05 3 .Exhibit 7.

however. •  The arbitrager will exploit the imbalance by investing in whichever currency offers the higher return on a covered basis.Interest Rates and Exchange Rates •  The spot and forward exchange rates are not. the potential for “risk-less” or arbitrage profit exists. constantly in the state of equilibrium described by interest rate parity. •  This is known as covered interest arbitrage (CIA) and an example can be found in Exhibit 7. •  When the market is not in equilibrium.7>>> (next slide) IIMB/ PCN/ INT FIN/ L05 4 .

7 Covered Interest Arbitrage (CIA) IIMB/ PCN/ INT FIN/ L05 5 .Exhibit 7.

Covered Interest parity •  IRP relation can be approximately interpreted as “the annualized premium/discount in the forward exchange market should equal the annualized difference in exchange rate between the two currencies” •  See problems in page 212 and 213… •  Impact of “market imperfections”… an American firm might be able to borrow cheaper in the US than in the Euro dollar market… see problem in PGA CH 8 page 214/215 IIMB/ PCN/ INT FIN/ L05 6 .

(Exhibit 7.Interest Rates and Exchange Rates •  A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA). investors borrow in countries and currencies exhibiting relatively low interest rates and convert the proceed into currencies that offer much higher interest rates.8) >>> see next page •  In this case. IIMB/ PCN/ INT FIN/ L05 7 . choosing to remain uncovered and accept the currency risk of exchanging the higher yield currency into the lower yielding currency at the end of the period. •  The transaction is “uncovered” because the investor does not sell the higher yielding currency proceeds forward.

the investor exchanges the dollars back to yen to repay the loan. At the end of the period.8 Uncovered Interest Arbitrage (UIA): The Yen Carry Trade In the yen carry trade. dollar where the funds are invested at a higher interest rate for a term.Exhibit 7. IIMB/ PCN/ INT FIN/ L05 8 . the investment may result in significant loss. If the spot rate at the end of the period is roughly the same as at the start. the yen were to appreciate versus the dollar over the period. pocketing the difference as arbitrage profit. converts the proceeds to another currency such as the U.S. If. or the yen has fallen in value against the dollar. however. the investor profits. the investor borrows Japanese yen at relatively low interest rates.

3. tax rates.3. hence the arbitrage outcomes can be different •  Covered interest arbitrage… See page 216 (8. Interest rates … bid –ask spreads •  Bid rates is what banks will pay on deposits and ask rates will be the interest rate they charge on loans •  Different firms will be required to borrow at different rates.3.Arbitrage with Transaction Costs •  Exchange rates… bid-ask spreads. speculators IIMB/ PCN/ INT FIN/ L05 9 . Arbitragers.3) –  Political risks.1) •  One-way arbitrage… see PGA page 218 (8. –  presence of corporates.2) •  Covered Interest Arbitrage in practice… see PGA page 220 (8.

Swaps and Deposit market •  Arbitrage between FX swap market and the Eurodeposit market –  Lend in one currency and borrow in another! –  Banks monitor their swap quotes so that they are not out of line with the forward rates implied by the Eurodeposit rates •  •  •  •  See example in PGA pg 223 Inter-bank forward dealing: see dialogue on page 225 How does this work? PGA pg 225 In summary the inter-bank forward market is really a market for duplicating the money market (lending – borrowing) transactions via the currency market. IIMB/ PCN/ INT FIN/ L05 10 .

can take or make delivery between any two dates. at its option. •  See page 227 for an example •  Forward-forward swap (Swap position): Swap between two forward dates •  See page 228 for an example … •  In this case the treasurer is speculating on the interest rate differential.•  Options Forward It is a forward contract in which the counterparty (corporate customer). known as option period . the risk of spot exchange rate is eliminated IIMB/ PCN/ INT FIN/ L05 11 .

48% for 6 mths) •  Exchange Rate Agreements (ERA) –  Based on the Fwd-Fwd swap example (page 210)… –  dealer agrees to buy GBP 9mths fwd at a discount of 177 pips relative to its 3 mth rate –  After 3 mths.107 for 6 mths/ 1. except only spread and spot adjustments are involved •  Let us work out forward rate computations A. gain 10338 (GBP 1 mio@ .2 example 1 (page 224) •  Please work out early delivery. cancellation and extension of forward contracts A. gain is 7400(GBP 1 mio @ 1.8.F-F Swap •  Forward-Forward Swap (page 208) •  Forward Spread Agreement(FSA) –  Based on Forward interest rates –  The FSA seller (example page 209). locks in a 6 mth discount of 2.4 (page 233) IIMB/ PCN/ INT FIN/ L05 12 . if discount is 1%.8.48% on GBP with reference to the 3 mth rate –  After 3 mths.035) •  Forward Exchange Agreements –  Same as F-F swap. if discount is 70 pips.

•  Net settled in USD depending on the difference in NDF contract rate and the exchange rate prevailing at maturity. example… USD/INR price discovery in Dubai! •  Need for Forward and Futures market in the domicle country of the currency IIMB/ PCN/ INT FIN/ L05 13 . •  See example in page 240 … and discuss the table •  NDF has several adverse ramifications. but no underlying delivery of the foreign currency. •  NDF contract are exchange rate contracts.Non-deliverable Forwards •  Not all currencies have freely tradable forward markets •  In such cases NDF provides a good way to protect the dollar value of foreign currencies and reduce inherent uncertainties.