International Financial Management

P G Apte

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COVERED INTEREST ARBITRAGE
A fund manager sees the following rates:
USD/JPY spot: 120.00 3-month forward: 117.00
3-month Euro$ interest rate: 6% 3-month Euro¥ : 2%
$1 in a 3-month deposit becomes $1.015 at maturity
$1 convert spot to ¥120, deposit, sell maturity value of deposit
forward. You will have $[120(1.005)/117] = $1.0308
A riskless arbitrage profit of 1.58 cents per dollar. More than
6% p.a. without any currency risk.

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8.2 Arbitrage Without Transaction Costs
Covered Interest Arbitrage: Generalisation
• A German investor choosing between Eurodollar
and Euro deposits does not want to incur exchange
rate risk
Assume no transaction costs i.e. no bid/offer spreads in
forex or money markets
S: the EUR/USD spot rate
Fn: the EUR/USD forward rate for the n-year
maturity (n= N/360 or N/365 N= No.of days to
maturity)
iEUR : Euro Interest rate iUSD : USD Interest rate

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8.2 Arbitrage Without Transaction Costs
– Maturity value of EUR 1 in a n-year EUR deposit:
EUR (1 + niEUR)
– To invest in Eurodollar and eliminate all exchange risk
investor must
• Convert EUR into USD spot
• Invest in Eurodollar deposit
• Sell the USD proceeds of the deposit forward for
EUR
– Maturity value of 1EUR invested in this fashion is
EUR[(S)(1 + niUSD)/(Fn)]

What if [(S)(1 + niUSD)/(Fn)] (1 + niEUR) ?

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8.2 Arbitrage Without Transaction Costs
– Suppose (1 + niEUR) > S/Fn(1+niUSD)
– A large number of arbitragers would want to liquidate
dollar deposits or borrow dollars, sell USD vs. EUR in
spot market, demand EUR deposits and sell EUR vs.
USD forward
Resulting Market forces would lead to:
Increase in iUSD, increase in S, fall in iEUR, fall in Fn

If (1 + niEUR) < S/Fn(1+niUSD)

Market forces would lead to decrease in iUSD, decrease in S,

rise in iEUR, rise in Fn. In either case, the result would be

(1 + niEUR) = (S/Fn)(1+niUSD)
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 8.2 Arbitrage Without Transaction
Costs
• Covered Interest Parity Theorem
– In the absence of restrictions on capital flows and
transaction costs for any pair of currencies A and B the
following relation holds
– (1 + niA)/(1 + niB) = S(A/B)]/[Fn(A/B)]
– [Recall that S(A/B) and F(A/B) re stated as units of B
per unit of A]
– This is the “Covered Interest Parity (CIP) Relation”
– Exploiting the departure from this relation is “Covered
Interest Arbitrage” It is not a causal relation but an
equilibrium condition

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8.2 Arbitrage Without Transaction
Costs
– If iA > iB then Fn < S A at forward discount, B at
forward premium
– and if iA < iB then Fn > S A at premium, B at
discount
The CIP relation can be written as:
(1/n) [(Fn - S)/S](100) = (100)(1/n) (niB – niA)/(1 + niA)
≈ (100)(1/n) (niB – niA)
% Annualised Forward Discount/Premium
≈ interest rate differential in %
Currency with higher interest rate will be at discount.

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8.2 Arbitrage Without Transaction
Costs

(niB – niA) Interest

Parity Line

[(Fn – S)/S] (1 + niA)

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8.2 Arbitrage Without Transaction Costs
• One-Way Arbitrage : Using money market to
avoid dealing in spot/forward market
– An example: USD/CHF spot : 1.6450, 6-month
forward : 1.6580, Euro$ 6-month interest rate : 4.50%
p.a., EuroCHF 6-month interest rate : 6.50% p.a.
Case I: A Swiss firm need USD now. Buy spot or borrow
USD, buy USD forward to repay loan
Case II : A US firm needs CHF 6 months later. Buy
forward or borrow USD now, convert to CHF spot,
deposit, use deposit on maturity, repay USD loan

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 8.2 Arbitrage Without
Transaction Costs (contd.)
– Generalizing the result:
• Assuming one unit B is borrowed for a period of n
years. To repay the loan the firm must have [1+niB]
units of B when the loan matures.
• To acquire it in the forward market, the firm must
have Fn(B/A)[1+niB] units of A when the forward
contract matures.
• So the firm must now set aside an amount of A
given by [Fn(B/A)(1+niB)]/(1+niA).

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8.2 Arbitrage Without Transaction Costs
If the cost of the direct spot purchase is not to exceed the
cost of the indirect transaction :
Fn(B/A)(1+niB)/ (1+niA) ≥ S(B/A)
If this inequality does not hold, all traders who need B
now will shun the spot market and there will be no spot
demand for B
Suppose it is satisfied as a strict inequality then
Fn(B/A) (1+niB) / (1+niA) > S(B/A)

Now those who need B in future will avoid forward

market. Hence must have
Fn(B/A) (1+niB) / (1+niA) = S(B/A) CIP

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 8.3 Arbitrage With Transaction Costs
• The Foreign Exchange Market
– For any pair of currencies X and Y,
– Spot (Y/X)bid = Sb = S(1-ts)

– Spot (Y/X)ask = Sa = S(1+ts)

– S is the "mid rate”. The spread 2tsS is the transaction

cost.
– Forward (Y/X)bid = Fb = F(1-tf)

– Forward (Y/X)ask = Fa = F(1+tf)

– F is the "mid-rate" and 2tfF is the transaction cost in the
forward market
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8.3 Arbitrage With Transaction Costs
• Eurodeposit Markets
– Bid rates are rates banks will pay on deposits;
Ask rates are rates they would charge on loans
– The bid rate for EuroX deposits iXb = iX(1-tX)
– The ask rate for EuroX loans iXa = iX(1+tX)
– The bid rate for EuroY deposits iYb = iY(1-tY)
– The ask rate for EuroY loans iYa = iY(1+tY)

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8.3 Arbitrage With Transaction Costs
• Covered Interest Arbitrage with Transaction Costs
– Consider the following rates
• GBP/USD spot : 1.5625/35
Euro$ deposits : 8¼ - 8½
• Euro£ deposits : 125/8 - 13
– Consider : Borrow sterling for 1 year, convert spot to
dollars, invest dollars for one year and sell the maturing
dollar deposit forward. For no arbitrage profit:
– 1.5625(1.0825)/Fa ≤ 1.13 or
– [1.5625(1.0825)/1.13] ≤ Fa or Fa ≥ Sb(1+ixb)/(1+iya)
– For arbitrage in reverse direction
– Fb ≤ Sa(1+ixa)/(1+iyb)
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–
8.3 Arbitrage With Transaction Costs
Fa≥ βSb Fb ≤ αSa Fa > Fb

β = (1+ixb)/(1+iya) α = (1+ixa)/(1+iyb) β< α

•---------------•
βSb αSa
•-----------------------• •---------------------• Acceptable
Fb Fa Fb Fa
•--------------• •-------------•
Fb Fa Fb Fa
Not Acceptable

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8.3 Arbitrage With Transaction Costs
• One-Way Arbitrage with Transaction
Costs
– The following rates are available in the market :
– Spot USD/CHF : 1.6010/20
3-months Forward : 1.5710/25
– CHF 3-month rates : 4 - 4¼
EuroUSD 3-month rates : 121/8 – 123/8
– Covered interest arbitrage is not profitable with
these prices

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8.3 Arbitrage With Transaction Costs
– Consider the case of a Swiss firm which needs $10
million 3 months from now. The firm has access to the
Eurodeposit markets i.e. can borrow or lend at the Euro$
and CHF rates quoted
– the firm buys dollars forward, each dollar will cost
CHF1.5725 three months later
– Alternatively it can borrow CHF, convert spot to
dollars, place dollars in a euro$ deposit and use these to
make the payment. The cost per dollar in terms of CHF
outflow 3 months later is
[1+0.25(0.0425)]
CHF (1.6020) {------------------------}
[1+0.25(0.12125)]
= CHF 1.5714 , saves CHF 11000
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8.3 Arbitrage With Transaction Costs
– A firm needs currency Y now. It can obtain it in the
spot market by selling X or it can get it indirectly as
follows.
– It borrows Y in the Eurodeposit market;
– Sets aside a certain sum of X earning interest
– Sells forward the maturity value of this X deposit
against Y to repay the Y loan.
The condition which makes direct purchase no more
expensive than indirect acquisition is
• Fa ≥ (Sa) [1 + iX(1-tX)] /[1 + iY(1+tY)]
Fa ≥ β Sa
Same argument applied to buying X will lead to
Fb ≤ α Sb
– 18
Now consider a firm which needs Y a year from now.
Buy it forward or borrow X, convert to Y, deposit Y and
use the deposit proceeds. For cost of direct forward
purchase to be no greater than indirect acquisition via
money market
Fa ≤ αSa

In the same manner, we can get the condition

Fb ≥ βSb
If some of these are violated market players will take
advantage to save costs.

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 Arbitrage With Transaction Costs
Occasionally depending upon the interest rates
accessible to a firm, some of these may be violated.
In particular, if rates accessible to a firm are different
from Euromarket rates, firm may find one-way
arbitrage profitable.
Thus indirect acquisition of a currency via money
market and spot market may work out to be cheaper
than a forward purchase.
The firm must always examine such possibilities.

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 Arbitrage With Transaction Costs
• Covered Interest Arbitrage in Practice
– Given the spot bid-ask rates as well as bid-ask rates in
deposit markets, covered interest parity does not imply
a unique pair of forward bid-ask rates
– Political risks, Taxes and Transaction costs are also
relevant factors.
– If interest earned and exchange gains are taxed at
different rates, the covered parity conditions must be
modified.
– For banks this is generally not true. They are the
dominant players in the money and exchange markets.

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 Swaps and Deposit Markets
• Banks will constantly monitor its swap rates so that they
are not out of line with the forwards implied by
Eurodeposit rates
• A bank can "manufacture" a swap quote from Eurodeposit
rates or manufacture a Eurodeposit rate from swap quotes
– Suppose a customer approaches a bank for a 3 month
CHF-Italian lira swap. The customer will sell CHF 1
million spot against ITL and buy CHF 1 million 3
months forward against ITL. The rates are as follows
CHF/ITL Spot : 755/765
EuroCHF 3 month : 6 - 6¼
Eurolira 3 month : 15 - 15½
•

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 8.4 Swaps and Deposit Markets
– What swap margin should the bank quote ?
• Assume that the swap is done off a spot rate of
CHF/ITL 760.00. The bank borrows ITL 760
million at 15½ % and delivers it to the customer. It
invests the CHF 1 million received from the
customer at 6%
• At maturity, the bank must repay ITL 789.45m. Its
CHF deposit will have grown to CHF 1.015m. The
bank will break even if it charges a rate of 777.78
lire per CHF on the forward leg of the swap
• This is just CIP at work. In a similar fashion, the
bank can work out a breakeven deposit/loan rate in
currency B by looking at deposit/loan rate in
currency A and the swap margin between A and B

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 Interbank Forward Dealing
• The buyer is really buying the swap points
i.e.the interest rate differential and the spot
risk is removed buy doing a spot deal in
conjunction with the forward deal
• The interbank forward market is really a
market for duplicating the money market
lending-borrowing transactions via the
currency market

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 Interbank Forward Dealing
• A movement in spot rate after a forward
deal is done (accompanied by its companion
spot deal), will change swap points for a
given interest rate differential but may also
affect the interest rate differential
• The "spot risk" in forward transactions:
Spot rate movements give rise to temporary
short and long positions in different
currencies and hence interest expenses and
earnings

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 Option Forwards
• Banks offer a contract known as option
forwards in which the rate of exchange
between the two currencies is fixed at the
time the contract is entered into as in a
standard forward but the delivery date is not
a fixed date
• One of the parties can, at its option, take or
make delivery on any day between two
fixed dates. The interval between these two
dates is the option period
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FORWARD-FORWARD SWAPS AND
RELATED PRODUCTS
Forward-Forward Swaps

GBP/USD Spot : 1.4995/1.5005

3-Month swap : 92/83 9-Month swap : 290/269
3-Month Eurodollars : 5.50% 9-Month Eurodollars : 6.25%
3-Month Eurosterling : 8.00% 9-Month Eurosterling : 8.80%

A trader expects USD interest rates to rise and GBP rates to

soften. This would imply a reduction in the premium on the
USD.

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He undertakes the following two spot-forward swaps:

Buy GBP 1mio spot sell 3-month forward

Sell GBP 1mio spot buy 9-month forward

Both swaps are done off a spot of 1.5000. Using this spot, the 3
and 9-month outright forwards are 1.4908 and 1.4731
respectively:

1.4908 = 1.5000[(1+(0.055/4))/(1+(0.08/4))] = 1.5000-0.0092

1.4731 = 1.5000[(1+0.0625*0.75)/(1+0.088*0.75)]
= 1.5000-0.0269
Effectively the trader has done a forward-forward swap; sell
GBP 1mio 3 months forward and buy GBP 1mio 9 months
forward both against USD. The spot position is washed out.
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At 3 months suppose we have:

GBP/USD Spot : 1.4500

6-month Eurodollar : 7.00%

6-month Eurosterling : 8.00%

6-month GBP/USD outright : 1.45(1.035/1.04) = 1.4430

The trader buys GBP 1mio spot at 1.45 and delivers on the
forward leg of the 3-month swap:

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CASH FLOWS:
At 3 months:
STG + 1mio USD –1.45mio Spot purchase of STG
STG –1mio USD +1.4908mio Delivery on the original spot-3
month swap.
Net : USD 0.0408mio = USD 40800
He closes out the 9-month position by selling STG 1mio 6
months forward at the rate of 1.4430.
At 9 months:
STG +1mio USD –1.4731mio Delivery on the original spot-9
month swap.
STG –1mio USD + 1.4430m Delivery on the 3-9 month swap.

Net : USD –0.0301mio = USD -30100.

TOTAL NET USD (40800-30100) + Int. on USD 40800
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STARTING RATES ONCE MORE
GBP/USD Spot : 1.4995/1.5005
3-Month swap : 92/83 9-Month swap : 290/269
3-Month Eurodollars : 5.50% 9-Month Eurodollars : 6.25%
3-Month Eurosterling : 8.00% 9-Month Eurosterling : 8.80%

Outrights:

3 months: 1.4903/1.4922
9 months: 1.4705/1.4736

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Forward Spread Agreement (FSA)

With the data given above, the 3-9 month discount on the sterling
reflects the 3-9 month forward interest rate differential. The 3-
month forward 6-month rates are calculated as follows:

Eurodollars: (1+0.055*0.25)(1+r$3,9*0.5) = (1+0.0625*0.75)

Eurosterling: (1+0.08*0.25)(1+r£3,9) = (1+0.088*0.75)

This gives : r$3,9 = 6.54% r£3,9 = 9.02%

The outright forward rates for 3 and 9 months today reflect the
differential (r£3,9 - r$3,9) :

1.4731 = 1.4908 [(1+ r$3,9/2)/(1+ r£3,9/2)]

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The FSA seller locks in a 6-month discount of 2.48% on the
sterling with reference to the 3-month rate. Suppose the
notional principal is GBP 1mio. Notionally he agrees to buy
sterling (i.e. sell the “foreign currency”) at 9-months at a rate
2.48% below its rate at 3 months.

Three months later suppose the 6-month rates are, as above,

7% for dollars and 8% for sterling. Now the actual 6-month
discount on sterling will reflect this 1% differential. The FSA
buyer notionally sells sterling at a 1% discount. His gain is
1.4% on STG 1mio for 6 months or STG 7000. This is paid at
9 months or its discounted value immediately using the 6-
month STG discount rate of 8% p.a.

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STARTING RATES ONCE MORE
GBP/USD Spot : 1.4995/1.5005
3-Month swap : 92/83 9-Month swap : 290/269
3-Month Eurodollars : 5.50% 9-Month Eurodollars : 6.25%
3-Month Eurosterling : 8.00% 9-Month Eurosterling : 8.80%

Outrights:

3 months: 1.4903/1.4922
9 months: 1.4705/1.4736

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Exchange Rate Agreements (ERAs)

This product was launched by Barclays bank. It is quite

similar to FSA. The ERA seller agrees to receive a 3-9 USD-
STG spread of 177 pips implied by the starting spot, and the 3
and 9 month USD and STG interest rates. In effect, the ERA
seller expects the pound interest rate to fall and/or US interest
rate to rise leading to a reduction in the premium on USD
(discount on GBP). He agrees to buy GBP 9 months forward
at a discount of 177 pips relative to its 3 month rate. At 3
months he will close out by selling GBP then 6 months
forward at a spread to spot existing at that time. However, the
bet is only on the spread. This can be looked at as follows:

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EXCHANGE RATE AGREEMENT(Contd.)
Today, the ERA seller agrees to do the following transactions at 3
months:

Sell GBP spot, buy 6 months forward at a 6-month

premium/discount implied by today’s 3 and 9 month forward
rates.

Buy GBP spot, and sell 6 months forward at the actual

premium/discount existing at that time.

Effectively, he will collect the difference between the 3-9 month

spread implied by today’s rates and pay the 6 month spread that
will materialize at the end of 3 months.
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The notional principal is STG 1mio. If at the end of 3 months the
rates are :
USD/STG spot: 1.4500.
6-month interest rates are 7% and 8% for USD and STG
respectively.
The actual 6-month USD-STG spread is
1.4500 – 1.4500[(1.035/1.04)] = 1.4500-1.4430 = 70 pips.

The ERA seller is paid

USD[(0.0177-0.0070)*1mio/(1.035)] = USD 10338.16 = STG
7129.77
In general, the ERA seller is paid
(CFSt,T-SFSt,T) NP: Principal
A = -{NP × ------------------------} CFS: Contract Spread at t=0
[(1+rt,T×(T-t)] SFS: Actual Spread at t
rt,T: Int. rate at t
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Forward Exchange Agreements (FXAs)

This product reproduces the payoff of the forward-forward swap

without actually having to take on the two swaps on the balance
sheet. Continuing the same example, the settlement amount A
paid to the FXA seller (paid by FXA seller if negative) is
calculated as :
[(F0,t-St) + (CFSt,T-SFSt,T)]
A = -{NP × ---------------------------------} + NP(F0,t-St)
[(1+rt,T×(T-t)]

The contract is initiated at time 0 (zero). The FXA period starts

at time t and ends at time T. Both t and T are measured in years.
NP, CFSt,T, SFSt,T and rt,T are as defined above. F0,t and St are
forward rate at time 0 for maturity t and spot rate at time t.
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 Foreign Exchange Rates in India
• An active forward rupee-dollar market with banks
offering two-way quotes has evolved in India
• The rupee-dollar spot forward margin is not entirely
determined by interest rate differentials due to exchange
controls on capital account transactions
• With liberalisation, the correspondence between interest
rate differentials and sap margins is closer than in the past.
• Other forward rates computed as cross rates
• For INR-USD forward quotes upto one year are available.

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 Foreign Exchange Rates in India
• Interbank money market has just begun to develop
with active interbank deposit trading and MIBOR
(Mumbai Interbank Offered Rate) as the market
index
• Supply of and demand for forward dollars arising
out of exporters and importers hedging their
receivables and payables
• Forward contracts in the Indian market are usually
option forwards though banks do offer fixed date
forwards if the customer so desires

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 Foreign Exchange Rates in India
• Absence of a tight relationship between interest
differentials and forward premia also opens up arbitrage
opportunities for exporting firms related to their credit
requirements
• All forward transactions are for the purpose of hedging an
underlying exposure such trade related payables and
receivables or approved capital account transactions such
as debt service
• In the absence of an active money market in India and
hence the interest parity linkage, it is very difficult for
dealers to assess the correct forward rate which they
should offer their customers

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 Foreign Exchange Rates in India
• “Third currency forwards" are permitted i.e.a firm
can buy (sell) say JPY forward against USD and
leave the USD exposure open.
• In recent years there has been considerable
deepening of the forward markets in India against
the major currencies like USD, GBP, DEM and
JPY

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 Forward Rate Computations
Example 1
On June 7 1999 a client discounted his DEM 2 million usance
90 days export bill with the export desk. The export desk reported
this to the corporate dealer and asked for the conversion rate. The
corporate dealer asked the USD/INR spot interbank dealer for
spot quote and the USD/INR forward interbank dealer for 3
months forward swap points. The quotes given are say 42.92/93
for value spot and the forward dealer asked the corporate dealer to
look at INRF= page for relevant swap points.
DEM is a legacy currency and hence, must be computed in terms
of EUR and converted at its fixed exchange rate of EUR / DEM
1.95583
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Forward Rate Computation
Client sells DEM (or equivalent EUR) and buys USD and
Client sells USD and buys INR
Thus, the computation is as follows :
USD / INR Spot Bid :: 42.92
From the Reuters page , the forward points are :
Spot over 31 Aug 99 :: 48.50 / 50.50
Spot over 29 Sep 99 :: 68.00 / 70.00
Thus for Sept.9,1999 the bid points for USD/INR are
interpolated as
= [(68.00 – 48.50) / 29] * 9 days + 48.50 = 6.05 + 48.50
= 54.55 = 55 pips premium
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Forward Rate Computation
EUR / USD Spot Bid :: 1.0378
EUR / USD 3 month forward points bid :: 65.00 pips premium
from the Reuters page directly (otherwise use interpolation)
Thus, the outright DEM / INR 3 month outright forward rate for
Sept. 9, 1999 is
= [ 42.92 + 0.55 ] / [ 1.95583 / ( 1.0378 + 0.0065 ) ]
= 43.47 / [ 1.95583 / 1.0443 ] = 43.47 / 1.872862
= 23.2105 = 23.21
The corporate dealer would deduct his margin, say 3 paise, and
arrive at the net bid rate to the client as Rs. 23.18 per DEM

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Forward Rate Computation
It is June 7. A client wants to buy JPY 25 million, for value three
months from spot date. The import desk reports this to the
corporate dealer and asks for the conversion rate.
Cross Rate: Client sells INR buys USD; Sells USD buys JPY
The corporate dealer gets the USD / INR rates from the Reuters
INRF page.
USD / INR Spot Ask :: 42.93
USD / INR 3 month forward points : ?? From the INRF page
Spot over 31 Aug 99 :: 48.50 / 50.50
Spot over 29 Sep 99 :: 68.00 / 70.00

46
Thus for Sept. 9, the ask points for USD/INR are interpolated
as
= [(70.00 – 50.50) / 29] * 9 days + 50.50
= 6.05 + 50.50 = 56.55 = 57 pips premium
USD / JPY Spot Bid :: 122.30
USD / JPY 3 month forward points bid :: -154.50 pips
discount from the USD/JPY page. Recall that a pip for JPY is
0.01.
Thus, the outright JPY / INR 3 month outright forward rate for
Sept. 9, 1999 is
= [ 42.93 + 0.57 ] / [ 122.30 – 1.5450] = 43.50 / [ 120.7550]
= 0.360234 or INR 36.0234 per 100 JPY. Add a
spread of say 3 paise. Rs.36.05 per 100 JPY.
47