covered interest arbitragemahmood

8/13/2019 Covered Interest ArbitrageMAHMOOD

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Mahmood-ur-Rahman

Lecturer, BIBM


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Foreign Exchange MarketForeign Exchange Market is the

organizational framework wherethe various national currencies arebought and sold.

Practically it is a worldwide market,

which is made up of individuals,commercial banks and otherauthorized agents.


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ArbitrageArbitrage: Locking in a riskless profit from price

disequilibria or distortions indifferent markets.


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ArbitrageCurrency Arbitrage:It refersto the purchasing of

foreign currency where itsprice is low and selling itwhere the price is high.


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ArbitrageArbitrage may be due tointerest rate differences in

two financial centers,which is known as interestarbitrage.


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Hedging:Foreign exchangerisks can be avoided orcovered by Hedging.

This usually involves anagreement today to buy or sell

a certain amount of foreigncurrency at some future date

at a rate agreed upon today.

Hedging


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Speculation: It is opposite of

hedging. While a hedger seeks toavoid or cover a foreign exchange

risk for fear of loss, thespeculator accepts or even seeksa foreign exchange risk in the

hope of making a profit.

Speculation usually occurs in

the forward exchange market.

Speculation


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Covered Interest ArbitrageCovered Interest Arbitrage: It refers to

the transfer of liquid funds from onemonetary center and currency toanother to take advantage of higherrates of return (or interest) and at thesame time the resulting foreign

exchange risk is covered or hedged bya forward sale of the foreign currencyto coincide with the maturity of the

foreign investment.


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Covered Interest Arbitrage: ExampleIf we desire to capitalize on

relatively high rates of interest inthe UK have funds available for 90days.

The interest rate is certain: only thefuture ER at which we will exchangepounds back to USD is uncertain.

The strategy is as follows:1. On day 1, convert USD into poundsand set up a 90-day deposit inBritish bank.


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Covered Interest Arbitrage: Example2. On day 1, engage in forward

contract to sell pounds 90-dayforward3. In 90 days when the deposit

matures, convert the pounds to USDat the rate that was agreed upon inthe forward contract.


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Covered Interest Arbitrage: Example

Assume the following information:

We have USD 8,00,000 to invest

The current spot rate of pound is

$1.60The 90-day forward rate of pound is

$1.60

The 90-day interest rate in USA is 2%The 90-day interest rate in UK is 4%


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Based on the information weshould proceed as follows:

On day 1, convert $8,00,000 to

5,00,000 pounds and deposit inBritish bank


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On day 1, sell 5,20,000 pound 90-day forward. By the time thedeposit matures and we will have

5,20,000 pounds.In 90 days when deposit

matures, fulfill the forwardcontract obligation byconverting 5,20,000 pounds into

$8,32,000

t


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mpact oActivity Impact

1. Using USD to purchasepounds in the spot market

Upward pressure on the spotrate of pound

2.Engaging in forward

contract to sell pounds

Downward pressure on the

forward rate of the pound

3. Investing funds from US

to UK

Possible upward pressure on

US IR and downward

pressure on UK IR.

Original value Value after beingaffected by CIA

Spot rate: $1.60 $1.6200

Forward rate: $1.60 $1.5888

l d d


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Realignment due to Covered Interest

Arbitrage

As with other forms of arbitrage,market forces resulting from CIA

will cause a market realignment:Convert $8,00,000 to 4,93,827

pounds ($8,00,000/1.62)

Calculate accumulated pounds over90 days at 4% { 4,93,827 X 1.04} =

5,13,580 pounds

li d d


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Realignment due to Covered Interest

Arbitrage

Reconvert pound to dollar atforward rate 0f $ 1.5888 [ 5,13,580

X 1.5888] = $8,15,976Determine the yield earned fro

CIA:[(8,15,976-8,00,000)/8,00,000] =

.02 =2%


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SPECULATING ON EXCHANGE RATE

MOVEMENTS

Many commercial banks and othertypes of firms attempt to capitalize

on their speculation of exchangerate movements. To illustrate how abank may attempt to capitalize on

the expected change in a currencysvalue, assume the following:


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SPECULATING ON EXCHANGE RATE MOVEMENTS

Present short-term interest rates (annualized)

in the interbank market are as follows:

Currency Lending Rate Borrowing

Rate

Dollars 6.72% 7.2%

German

marks (DM)

6.48% 6.96%

Because brokers sometimes serve as

intermediaries between banks, the lending

rate differs from the borrowing rate.


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MOVEMENTS

Given the information, Chicago Bankcould:

Borrow $20 million.

Convert the $20 million to DM40million (computed as$20,000,000/$.50).

Lend the marks at 6.48 percentannualized, which represents a .54percent return over the 30-day period

[computed as 6.48% X (30/360)].



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MOVEMENTS After 30 days, the bank would receive

DM40,216,000 [computed asDM40,000,000(1 + .0054)].

Use the proceeds of the mark loan

repayment (on Day 30) to repay thedollars borrowed. The annual interest onthe dollars borrowed is 7.2 percent, or .6

percent over 30-day period [computed as7.2% X (30/60)]. The total dollarsnecessary to repay the loan is therefore$20,120,000 [computed as $20,000,000 X

(1 + .006)].



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MOVEMENTS Assuming that the exchange rate on Day

30 is $.52 per mark as anticipated, thenumber of marks necessary to repay thedollar loan is DM38,692,308 (computed

as $20,120,000/$.52 per mark). Given that the bank accumulated

DM40,216,000 from its mark loan, it

would earn a speculative profit ofDM1,523,692, which is the equivalent of$792,320 (given a spot rate of $.52 per

mark on Day 30).



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MOVEMENTS

This speculative profit was earnedby the bank without using anyfunds from deposit accounts, since

the funds were borrowed throughthe interbank market.



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MOVEMENTS

If Chicago Bank expected that themark would depreciate, it couldattempt to make a speculative profit

by taking positions opposite to thosedescribed in the previous example.

To illustrate, assume that the bank

expects an exchange rate of $.48 forthe mark on Day 30.



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MOVEMENTS It could borrow marks, convert them

to dollars, and lend the dollars out.

It could borrow marks, convert them

to dollars, and lend the dollars out. On Day 30, it could close out these

positions.

Using the rates quoted in the previousexample, and assuming the bank canborrow DM40 million, the following

steps could be taken:



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MOVEMENTS Borrow DM40 million.

Convert the DM40 million to $20million (computed as

DM40,000,000 X $.50). Lend the dollars at 6.72 percent,

which represents a .56 percent

return over the 30-day period.After 30 days, the bank wouldreceive $20,112,000 [computed as

$20,000,000 X (1 + .0056)].



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MOVEMENTS Use the proceeds of the dollar loan

repayment (on Day 30) to repay themarks borrowed. The annualinterest on the marks borrowed is6.96 percent, or .58% over the 30-dayperiod [computed as 6.96 X(30/360)]. The total marks necessaryto repay the loan is thereforeDM40,232,000 [computed asDM40,000,000 X (1 + .0056)].



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MOVEMENTS

Assuming that the exchange rateon Day 30 is $.48 per mark asanticipated, the number of dollars

necessary to repay the mark loan is$19,311,360

(computed as DM40,232,000 X $.48per mark).


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