International Finance

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

PGA Ch 8
ESM CH 7

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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.
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,
the forward rate discount or premium for the foreign
currency, except for transaction costs.
See Exhibit 7.6 >>>> (next slide)

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Exhibit 7.6 Interest Rate Parity (IRP)

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Interest Rates and Exchange

Rates
The spot and forward exchange rates are not, however,
constantly in the state of equilibrium described by interest
rate parity.
When the market is not in equilibrium, the potential for
risk-less or arbitrage profit exists.
The arbitrager will exploit the imbalance by investing in
whichever currency offers the higher return on a covered
basis.
This is known as covered interest arbitrage (CIA) and an
example can be found in Exhibit 7.7>>> (next slide)
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Exhibit 7.7 Covered Interest

Arbitrage (CIA)

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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
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Interest Rates and Exchange

Rates
A deviation from covered interest arbitrage is uncovered
interest arbitrage (UIA). (Exhibit 7.8) >>> see next page
In this case, investors borrow in countries and currencies
exhibiting relatively low interest rates and convert the
proceed into currencies that offer much higher interest
rates.
The transaction is uncovered because the investor does
not sell the higher yielding currency proceeds forward,
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.
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Exhibit 7.8 Uncovered Interest Arbitrage (UIA):

The Yen Carry Trade

In the yen carry trade, the investor borrows Japanese yen at relatively low interest rates, converts
the proceeds to another currency such as the U.S. dollar where the funds are invested at a higher
interest rate for a term. At the end of the period, the investor exchanges the dollars back to yen to
repay the loan, pocketing the difference as arbitrage profit. If the spot rate at the end of the period
is roughly the same as at the start, or the yen has fallen in value against the dollar, the investor
profits. If, however, the yen were to appreciate versus the dollar over the period, the investment
may result in significant loss.

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Arbitrage with Transaction Costs

Exchange rates bid-ask spreads; 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, hence
the arbitrage outcomes can be different
Covered interest arbitrage See page 216 (8.3.1)
One-way arbitrage see PGA page 218 (8.3.2)

Covered Interest Arbitrage in practice see PGA page 220 (8.3.3)

Political risks, tax rates,
presence of corporates, Arbitragers, speculators

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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.

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 Options Forward It is a forward contract in which

the counterparty (corporate customer), at its
option, can take or make delivery between any
two dates, known as option period .
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, the risk of spot exchange
rate is eliminated
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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 2.48% on GBP with
reference to the 3 mth rate
After 3 mths, if discount is 1%, gain is 7400(GBP 1 mio @ 1.48% 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, if discount is 70 pips, gain 10338 (GBP 1 mio@ .107 for 6 mths/ 1.035)

Forward Exchange Agreements

Same as F-F swap, except only spread and spot adjustments are involved

Let us work out forward rate computations A.8.2 example 1 (page 224)

Please work out early delivery, cancellation and extension of forward contracts
A.8.4 (page 233)
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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.
NDF contract are exchange rate contracts, but no underlying
delivery of the foreign currency.
Net settled in USD depending on the difference in NDF contract
rate and the exchange rate prevailing at maturity.
See example in page 240 and discuss the table
NDF has several adverse ramifications, example USD/INR
price discovery in Dubai!
Need for Forward and Futures market in the domicle country of
the currency
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