| What most traders understand about currency trading is the basic buying and selling of currency pairs based on what indicators will determine. These are basic trades that take place in the spot market. Currrency trading however involves much more than basic trades in the spot market. Since interest rates between two pairs are the overall driver of spot prices, other methods exist to trade pairs that are just as or even more profitable than trading the spot market. Arbitrage, forward contracts, bond yield correlations and spot differentials in interest rates called swaps are just a few opportunities I would like to highlight here.
The use of arbitrage opportunities exist to take advantage of the difference of interest rates between two nations. Arbitrage in currency trading simply means the simultaneous buying and selling of a currency pair to take advantage of interest rate differentials. Notice the difference between the prime rate in the United States and the prime rate in say New Zealand. The difference is 6 points. Notice the difference between the prime rate in Japan and New Zealand. The difference is 7.5 points. Arbitrage opportunities exist for many other pairs between nations. This is done through the forward contract that is traded over the counter.
A forward contract is an agreement between two parties to exchange different currencies at a future date. Its an organized market. Central banks, treasury departments, multi national corporations, banks, hedge funds, institutional investors, importers and exporters are all active traders of these markets almost 24 hours a day Sunday evening Eastern time to Friday afternoon Eastern time. All are using the opportunity of arbitrage to take advantage of the interest rate spreads that exist around the world. Some of these interest rate differentials are fleeting moments to longer term spreads that can last as much as 1 year or more. Once locked into a contract , the contract is binding on the parties no matter what the spot price may do.This is the purpose for entering into forward contracts and locking in an interest rate differential. Nobody knows where spot prices will be at any given time. Eventually however the discrepancy in prices usually reach its purchasing power parity where interest rate differentials become equalized. To take advantage of a forward contract opportunity through a bank, derivitive broker or investment firm, we must calculate a forward price to determine if an arbitrage opportunity exists. The formula: Spot price= 1+ term currency
interest rate x forward days
————-interest rate per year
base currency x
interest rate forward days
———interest rate per year.
Now we have a forward rate for one year but we could easily have a forward rate for three days, two days, 90 days or 6 months. Changng the length of time will change the numerator’s number of days which will change the forward rate. A transaction lasting less than seven days can be considered a swap while longer time frames are considered forward contracts. What transpires in a forward contract is simply borrowing money from a low interest rate nation to a higher interest rate nation or the borrowing of one currency to another. The forward rate price allows the borrower to be locked into the position for the life of the contract which will guarantee a riskless free trade with a nice profit at the end of the contract term.
Suppose now you know the forward rate between New Zealand and the United States, NZD/USD, and you wanted to lock into a forward contract for one year. Because New Zealand’s prime rate is so much higher than the United States, what you would do is borrow from the United States, the base currency and figure out what you would owe after one year. Keep the spot price in mind because that is the basis of your borrowing. Next take the money you borrowed from your USD and buy New Zealand dollars and deposit that money at the spot price. Now factor how much you will earn in one year with New Zealand interest. Keep in mind the forward rate. After one year, convert New Zealand earnings back to your currency at the forward rate. This is all profit, a nice profit using a riskless free trade. This trade is called the covered interest arbitrage. You must also know that you can bail out of your forward contract at any time. Just because you agreed on a one year term, you are not locked into that full year. Another way to approach this trade is through a quick swap.
Suppose Bank A in the United States offers the British Pound against the United States Dollar, GBP/USD at 9800. Bank B in London offers the same pair for 9805. What you would do is sell Bank A’s price and buy the London price. What would you profit with a million dollar trade or a10 million dollar trade. With this large of a transaction and with such a short time factor, you are only looking for a few pip differential to lock in another nice profit on a riskless free trade. Regarding forward pricing again.
If forward prices are less than spot prices, the currency is offered at a forward discount. Conversely, if forward prices are higher than spot prices, the currency is selling at a forward premium. In other words, if the base currency earns a higher interest than the quote currency, the base currency will trade at a forward discount and below the spot rate. If the base currency earns a lower interest rate than the quote currency, the base currency will earn a forward premium and trade above the spot rate. What will be determined here is the interest rate differential.
To calculate the interest rate differential, subtract the spot price from the forward price and divide by the spot price. Next multiply your answer by the period of the year. For a 90 day forward, multiply by 4, 1/4 of a year, for a 180 day forward multiply by 2, 1/2 of a year. This answer is the discount factor. A negative number will inform you the forward is trading at a discount while a positive number means the forward is trading at a premium. This equation will give you an idea whether to lock in a forward contract or wait for spot to make a better move before entering into a forward contract. This trade is called an interest rate arbitrage. It answers the question how much interest will you earn not necessarily how much money.
While it appears many steps are involved in computing a forward price, in actuality quote screens have forward prices already computed due to the fast changing pace of interest rates during any trading day. Interest rates begin the day with the Libor and the EIBOR rates and move up or down from there during the day. The LIBOR rate is the London Interbank Offering Rate where cash prices are first offered and the EIBOR is the European Interbank Offering Rate. The Interbanks quote currencies all day long 24 hours a day from Sunday night until Friday afternoon. Firms that specialize in these trading instruments such as swaps, forward contracts and interest rate arbitrages will allow you to see the various forward prices and swaps offered by many different places around the world. You the trader will also have the ability to take advantage of any opportunity as prices hit your screen. Many screens come equipped with specialized calculators to allow you to perform quick functions. This is needed as opportunities for swaps may exist for only a short period of time. Chances are Globex may be the preffered market.
A swap can be defined as the buying and selling of the same currency at the same time with two different delivery points. The two points may be two banks. What you are swapping here is the spot price against the forward price. But know that swaps can be traded in many different ways. Bond swaps, credit swaps, interest rate swaps and currency swaps are just a few mentionables.