FX Forward ArbitrageFX Forward Arbitrage

Currency Fwd ArbitrageCurrency Fwd Arbitrage Currency Forward pips (ECA-EURUSD) are generally Currency Forward pips (ECA-EURUSD) are generally

regarded as the ‘cost of carry’ of holding one currency regarded as the ‘cost of carry’ of holding one currency against the other. Bank traders/Hedgers will use these against the other. Bank traders/Hedgers will use these forward pips to calculate precisely the future exchange forward pips to calculate precisely the future exchange rate they will receive by ‘rolling out’ a Spot valued rate they will receive by ‘rolling out’ a Spot valued position to a future maturity. These markets have existed position to a future maturity. These markets have existed since the 1970’s. Apart from the speed aspect of the since the 1970’s. Apart from the speed aspect of the ECA-EURUSD trade, the Interest rate variable is the ECA-EURUSD trade, the Interest rate variable is the absolute KEY to direction/bias of the Forward market. absolute KEY to direction/bias of the Forward market. There are numerous methods to calculate Forward pips, There are numerous methods to calculate Forward pips, and there are numerous participants transacting ‘behind and there are numerous participants transacting ‘behind the scenes’ in the money and FX forward Market all the scenes’ in the money and FX forward Market all impacting on the direction of ECA-EURUSD. But the impacting on the direction of ECA-EURUSD. But the bottom line, Realizing Interbank Lending Rates, are bottom line, Realizing Interbank Lending Rates, are fundamentally crucial in accurately pricing forwards.fundamentally crucial in accurately pricing forwards.

What should I look at?What should I look at?

Euro$ vs Euribor (or STIR vs STIR)Euro$ vs Euribor (or STIR vs STIR) Equities.Equities. OIS vs Eonia (or short term swap vs STS)OIS vs Eonia (or short term swap vs STS) Fed fundsFed funds Deposit Markets ICAPDeposit Markets ICAP Credit spreadsCredit spreads T-BillsT-Bills UST, EGB, GILT yield curve spreadsUST, EGB, GILT yield curve spreads US, EUR, GBP swap spreads.US, EUR, GBP swap spreads.

ERX8/EDX8 vs EUIM1ERX8/EDX8 vs EUIM1 When markets become fixated on global issues normal methods When markets become fixated on global issues normal methods

become obsolete. Certainly over the last 3 trading weeks we have become obsolete. Certainly over the last 3 trading weeks we have seen a dramatic decoupling of money, Swap and FX markets. seen a dramatic decoupling of money, Swap and FX markets. Traders have to rely on more subjective, creative ideas in pricing Traders have to rely on more subjective, creative ideas in pricing risk as opposed to conventional techniques. Arbitrageurs are absent risk as opposed to conventional techniques. Arbitrageurs are absent from the markets. These Arbitrageurs generally keep our markets from the markets. These Arbitrageurs generally keep our markets within parameters preset by opportunities lying in other markets, for within parameters preset by opportunities lying in other markets, for example money markets, OIS swap markets. Slide 5 (ERX8/EDX8 example money markets, OIS swap markets. Slide 5 (ERX8/EDX8 vs EUIM1) which shows October Euro$ - October Euribor and how vs EUIM1) which shows October Euro$ - October Euribor and how that spread is correlated to the DEC EUR forward pips. In the last 3 that spread is correlated to the DEC EUR forward pips. In the last 3 weeks market dislocation, OCT/OCT spread has had correlations up weeks market dislocation, OCT/OCT spread has had correlations up to 85pct to the direction of the EUIM1. This will evaporate as we to 85pct to the direction of the EUIM1. This will evaporate as we return to more precise techniques (which are outlined on this power return to more precise techniques (which are outlined on this power point). But in the meantime you can use this spread to help you point). But in the meantime you can use this spread to help you manage your exposure in the next few weeks. I use Oct euro$ in manage your exposure in the next few weeks. I use Oct euro$ in preference to DEC as it is far closer to Interbank lending rates, and preference to DEC as it is far closer to Interbank lending rates, and represents by far the market perception and fears.represents by far the market perception and fears.

US Credit SpreadsUS Credit Spreads

Another market I would use in times of severe Another market I would use in times of severe dislocation will be US credit markets. Given the dislocation will be US credit markets. Given the Market became dislocated because of Credit Market became dislocated because of Credit issues and not direct economic issues, I look at issues and not direct economic issues, I look at Credit spreads to give me my Bias to Direction. Credit spreads to give me my Bias to Direction. Slide 7 shows the correlations of Credit spreads Slide 7 shows the correlations of Credit spreads to ECA-EURUSD pips during the last 6months. to ECA-EURUSD pips during the last 6months. As with the STIRS correlations have spiked As with the STIRS correlations have spiked higher to well over 80 pct. higher to well over 80 pct.

BOX TickingBOX Ticking

I suggest until normality returns, a I suggest until normality returns, a combination of Forward indicators from the combination of Forward indicators from the list provided. With core indicators being list provided. With core indicators being Credit spreads/Tbills/UST/equities. All of Credit spreads/Tbills/UST/equities. All of these 4 indicators having correlations of these 4 indicators having correlations of over 75 pct in the past 3 weeks.over 75 pct in the past 3 weeks.

Market dislocation still with us?Market dislocation still with us? Absolutely. Money markets still extremely fragmented and unreliable for Absolutely. Money markets still extremely fragmented and unreliable for

pricing Forward Pips. With still 100 bp arbitrage from EUR to GBP. pricing Forward Pips. With still 100 bp arbitrage from EUR to GBP. Borrowing GBP depo at 6.15 you can via the mispriced EURGBP forward Borrowing GBP depo at 6.15 you can via the mispriced EURGBP forward pips produce borrowing EUR 1m at 4.33 Pct. Which is 60 bps lower than pips produce borrowing EUR 1m at 4.33 Pct. Which is 60 bps lower than Libor. How this impacts you guys Arb-ing FX, well it means still you have to Libor. How this impacts you guys Arb-ing FX, well it means still you have to rely on subjectivity to price forwards. For those who want a detailed rely on subjectivity to price forwards. For those who want a detailed example of how forward Arbitrage works please contact me so I can run example of how forward Arbitrage works please contact me so I can run through some live examples. through some live examples.

Period EUR Depo Bid EUR Depo Offer EURGBP IMM pips EURGBP IMM pips Days GBP Depo Bid GBP Depo Offer

1M

4.880 4.930 12.000 15.000

30.000

6.100 6.150

4.166 3.754 7.685 7.041 7.294 6.876

SPOT 0.7809

Working With Slide 11 and how to Working With Slide 11 and how to price your IMM basis pips.price your IMM basis pips.

Table A (top) is a working example of Live 1M EURGBP Fwd pips with Table A (top) is a working example of Live 1M EURGBP Fwd pips with accompanying Deposit rates. With the market price of 12/15 in the 1Mth accompanying Deposit rates. With the market price of 12/15 in the 1Mth EURGBP forward pips you can clearly arbitrage markets as explained in EURGBP forward pips you can clearly arbitrage markets as explained in previous slides. Slide B (bottom) I have altered the current market price of previous slides. Slide B (bottom) I have altered the current market price of 1mth EURGBP to 7/8 from 12/15 and it removes any possible arbitrage 1mth EURGBP to 7/8 from 12/15 and it removes any possible arbitrage between Deposits and Fx forwards. So for me as equities rally and credit between Deposits and Fx forwards. So for me as equities rally and credit spreads slide lower, Fair value for this forward is round about 7/8 not 12/15. spreads slide lower, Fair value for this forward is round about 7/8 not 12/15. Arbitrage exists in money markets because of credit quality of Arbitrage exists in money markets because of credit quality of counterparties. Usually, and what IMM Fx ‘arbers’ are used to, is a Solid, counterparties. Usually, and what IMM Fx ‘arbers’ are used to, is a Solid, Liquid Money market with small arbitrage opportunities intraday. And hence Liquid Money market with small arbitrage opportunities intraday. And hence an enormous reduction in intraday volatility in forward pips. I personally like an enormous reduction in intraday volatility in forward pips. I personally like volatility and once Credit markets return to something of normality 2months volatility and once Credit markets return to something of normality 2months ago we can use these simple methods to see the shift in FX forwards ago we can use these simple methods to see the shift in FX forwards intraday. Our edge can be then speed and Market Understanding (including intraday. Our edge can be then speed and Market Understanding (including STIRS, deposits and OIS models) We can price forwards with accuracy to STIRS, deposits and OIS models) We can price forwards with accuracy to 1/10 of a pip when markets return. So this is something we should build. To 1/10 of a pip when markets return. So this is something we should build. To do this access to Accurate deposit Rates will enable us to be extremely do this access to Accurate deposit Rates will enable us to be extremely proactive in changing IMM forward Pips. proactive in changing IMM forward Pips.

How Deposit Rates affect your FX How Deposit Rates affect your FX Basis…..Basis…..

Period EUR Depo Bid EUR Depo Offer EURGBP IMM pips EURGBP IMM pips Days GBP Depo Bid GBP Depo Offer

1M

4.880 4.930 12.000 15.000

30.000

6.100 6.150

4.166 3.754 7.685 7.041 7.294 6.876

SPOT 0.7809

Period EUR Depo Bid EUR Depo Offer EURGBP IMM pips EURGBP IMM pips Days GBP Depo Bid GBP Depo Offer

1M

4.880 4.930 7.000 8.000

30.000

6.100 6.150

4.936 4.836 7.685 7.041 6.090 6.190

SPOT 0.7809

In ConclusionIn Conclusion

In my experience of Forwards, all forward In my experience of Forwards, all forward traders are situated in the Heart of any traders are situated in the Heart of any bank interest rate trading desk, and bank interest rate trading desk, and usually on the money market desk. So usually on the money market desk. So interaction between the two will enable us interaction between the two will enable us to combine Speed with market to combine Speed with market understanding.understanding.