The Great Peter Wadkins
just be aware of something that I learned at my own expense as chief dealer … I had a guy working for me who used to arbitrage forward points against AUD bill futures and USD Eurodollar interest rate futures. He used to hedge 100% of the face value (E.G. $1,000,000 ) with the equivalent amount of Euro futures (1 contract I think it was) the problem with futures is that they tend to out-perform or under-perform cash – always … a function of the market’s bias … so if everybody thinks US interest rates are going up and LIBOR is 1.0000% for arguments sake, the implied rate on the futures contract will be anywhere from that to 1.25% (and vice versa) you also have to calculate the impact of margin requirements in futures … this is called “tailing” at the time (1988/89 – whenever the AUD contract started trading on the IMM) we found that it was better to hedge something like 85-90% of face.
It’s a little known fact that many traders are unaware of … another issue is “spot effect” on forward points … as spot moves up and down the future value of the forward contracts are impacted by the value of foreign currency – E.G. AUD points are worth US$100 per 1 point on spot or presently AUD 99.78 (because AUD/USD is quoted USD per AUD. If AUD goes higher say 1.10 then those forward points are only worth AUD90 if AUD goes down 10% they are worth AUD110.
On small books it doesn’t matter but if you are carrying multi-billion dollar forward books those differences add up. Therefore any forward swap trader worth his salt has to hedge spot effect.
The best way to look at arbitrage is to understand that a forward swap is as you simply a loan and a borrowing simultaneously … just in different currencies … you borrow 1,000,000 AUD at 5.5% for one year it costs AUD 55,000 interest you lend USD 1.002,200 for 1 year at 1.0% and you receive USD 10,000 plus 1% on 2,200 $22 so $10,022 if you were to do that via interest rates you would have to convert the AUD you borrowed at 1.0022 and in a year’s time you would you would convert back at the spot rate applicable at the time.
As they did not want that risk they invented FX forward swaps so that the exchange rate was locked in at the same time and the difference between spot rates and outright forward rates was purely and simply the interest rate differentials or the difference in what you paid in I nterest in one currency versus what you would receive in another.
What complicates the issue is when you do actually arbitrage and interest rates are no longer theoretical but based upon what you can actually borrow at and what the investment rules (if any) allow you to invest in. I.E. if you can invest in muni bonds or AA corporate paper instead of “LIBOR” (or whatever is implied by the bank pricing the trade) you can make a spread … that’s when the repayment schedules become involved (monthly, quarterly, or annual interest payments) because then you have to calculate the impact of interest upon interest (net present valuing or compounding) That is why long dated forwards (one year or more) are trickier to price than one year or less …