Operations in the Trading Room


In this case, presented in Exhibit 8.3, the interest differential is also 3 percent. However, the swap rate of150 point for three months indicates a discount of 2.50 percent per annum on the three-month pound against the dollar.

The general rule is that in covered interest arbitrage, we shall want to invest in the higher-interest currency except when the discount in that currency is higher than the interest differential. Thus, in this case we will want to invest in the pound, the higher-interest-rate currency.

To generate pounds which can be invested without assuming any foreign exchange risk. we borrow dollars and swap them spot into pounds and back into dollars for three-month delivery. The cost of doing this will be:Interest rate on dollar borrowings7.00%
Swap rate against us (sell spot dollars against pounds; buy three-month dollars against pounds at a premium for dollars)+2.50 9.50% Net cost of pounds on a covered basis9.50%
The pounds obtained in the spot part of the swap transaction can be invested at 10 percent. The net result is a profit of 0.50 percent per annum.

Again, in this transaction all cash flows are matched: for every inflow in a given currency at a given date, there is an outflow. and vice versa. Also, the net exchange position is basically zero except for the net profit which can be covered in the forward exchange market. Interests earned accumulate in pounds while the interest on the borrowings is payable in dollars.

To eliminate this risk, the interest earned in the pound investment could be sold in the exchange market for three-month delivery at the initial 2.5 percent discount on the pound against the dollar.

This disequilibrium in the market will also tend to be short-lived. The arbitrage transaction described here will tend to move the various rates back into equilibrium.

Taking Advantage of Expected Changes in Interest Rates

If we anticipate a change in interest rates, we are also anticipating a change in the net accessible interest differential and. therefore, in the swap rate. We can take advantage of the expected change in rates in either the forex news

money market or in the foreign exchange market. In the money market, we will simultaneously borrow and invest in the currency whose interest we are expecting to change. However, the maturity of the borrowing will be different from that of the investment. In the foreign exchange market, we have to deal with two currencies. To take advan¬tage of the expected change in the swap rate, we will both buy and sell each currency simultaneously. However, the maturity of the buy and sell in each currency will be different. Let's illustrate the mechanics of this transaction.

Consider a case where the interest rate of a currency is expected to decrease. The cost summarize the present situation and the forecast.1 We expect interest rates on the pound will decline within a month, and so will the discount on the forward pound. How does one take advantage of this piece of intelligence?


In this market we want to lock in the present high return of 13 percent on placements in pounds. So, we make a placement for, say, six months. To finance this loan we need to raise funds; however, since we expect interest rates to decline in a month, we shall borrow the funds only for that period. Assuming that the pound interest rate changes as anticipated, the returns will be zero for the first month (lending and borrowing cost are the same) and 1 percent per annum for the remaining five months (13 percent on the loan less 12 percent borrowing costs). Author Resource:- The forex website is about forex news which supplies the latest articles regarding Forex Trading, reviews on good forex platforms for beginners, exchange rates, and more important information for the forex investor also individual forex traders can take advantage of the market expertise and financial strength of GAIN Capital Group and access an institutional currency trading platform.

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