ARBITRAGE THROUGH FORWARD

RATES
INTRODUCTION
FORWARD RATE

• A rate which is agreed between the bank and the investor for
buying and selling currencies at a future specified date.

ACTUAL FORWARD RATE (AFR)

• Rate actually quoted by bank for entering into a forward

exchange contract.
• Is equal to forward rate.

FAIR FORWARD RATE (FFR)

• To determine whether the AFR is appropriate or not.

• Helps us to calculate a forward rate that should be prevailing
forward rate,
 HOW TO CALCULATE FFR-
AN ILLUSTRATION

• Spot rate : 1$= ₹64

• Interest rate prevailing in India = 12%
• Interest rate prevailing in US = 7%

Determine the FFR in 1 year?

 SOLUTION
US INDIA
$1 ₹64
+7% +12%
$1.07 ₹71.68

After 1 year, $1.07 should be equal to ₹71.68.

=>$1.07 = ₹ 71.68
=> $1 = ₹71.68/$1.07
=> $1 = ₹66.99

Thus, one year FFR should be $1= ₹66.99

 SOLUTION USING FORMULA
Formula:
S(1 + iL ) 64(1+0.12)
FFR = -------------------- = ----------------------
(1 + iF ) (1+.07)
FFR = ₹66.99

Where,
FFR = Fair forward rate
S = spot rate = ₹64
iL = interest rate (local currency) = 12%
iF = interest rate (foreign currency) = 7%
ARBITRAGE WITH FORWARD CONTRACT

Making Riskless
Profits

Buying currency from one market and selling the

same in another market simultaneously.
 STEP1: To determine whether an
arbitrage opportunity exists or not?

To determine whether arbitrage opportunity

exists:
Compute FFR
Compare FFR with AFR.
 If FFR= AFR => No arbitrage opportunity exists.
 If FFR ≠ AFR => Arbitrage opportunity exists.

Thus, arbitrage opportunity arises only when

there is a mismatch between AFR & FFR.
 ILLUSTRATION
• Spot rate : 1$= ₹64
• Interest rate prevailing in India = 12%
• Interest rate prevailing in US = 7%
• One year FFR: $1= ₹66.99
• One year AFR: $1= ₹65.90

Does an arbitrage opportunity exists? If

yes, then
a) Explain the arbitrage strategy?
b) Determine the possible arbitrage gain?
 SOLUTION
Buy the
The $ is
underpriced
AFR<FFR underpriced in the
currency, i.e $, in
forward market
the forward market

To take a counter position, one has to

sell $ in the spot market.

Arbitrage Sell $ in spot market.

strategy Buy $ in forward market.
Arbitrage Sell $ in spot market.
strategy Buy $ in forward market.

P
How to arrange $ for “sell spot” ?
R
O • Borrow in US $ to arrange $
B
L
What do with ₹ obtained?
E
M • Invest in India with ₹ obtained.
S
 Arbitrage Sell $ in spot market.
strategy Buy $ in forward market.

Complementary Borrow in US
strategy Invest in India.

Core steps in arbitrage process:

1. Borrow in US.
2. Sell spot
3. Invest in India.
4. Buy forward.
Borr
• Borrow $1,00,000 in US @7% pa for one
ow
in
year.
US

Sell
• Sell $1,00,000 @ spot rat of $1=₹64.
spot

Inve
st in
• Invest ₹64,00,000 @12%pa for one year
Indi
a

Buy
• Buy forward (1year) $1,07,000 @ $1 =
For
war ₹65.90
d
 After one year

Realise investments ₹64,00,000 * 1.12 =

₹71,68,000

Honour the forward contract by paying

₹70,51,300 ($1,07,000 * ₹65.90)

RESULT:
ARBITRAGE GAIN = Inflow-Outflow
Repay the US Loan (with interest)
= ₹71,68,000 – 70,51,300 = ₹1,16,700
from the obtained $1,07,000.