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Arbitrage Strategy Using Forward Rates

This document discusses arbitrage through forward rates. It defines forward rates and explains how to calculate the fair forward rate (FFR) using interest rate differentials between countries. An arbitrage opportunity exists if the actual forward rate (AFR) does not equal the FFR. The document provides an example where the AFR is lower than the FFR in India, allowing an arbitrage strategy of borrowing dollars, selling in the spot market, investing the rupees in India, and buying dollars back via the forward market to close out the position and realize a riskless profit.

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Nishtha Gupta
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108 views13 pages

Arbitrage Strategy Using Forward Rates

This document discusses arbitrage through forward rates. It defines forward rates and explains how to calculate the fair forward rate (FFR) using interest rate differentials between countries. An arbitrage opportunity exists if the actual forward rate (AFR) does not equal the FFR. The document provides an example where the AFR is lower than the FFR in India, allowing an arbitrage strategy of borrowing dollars, selling in the spot market, investing the rupees in India, and buying dollars back via the forward market to close out the position and realize a riskless profit.

Uploaded by

Nishtha Gupta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

ARBITRAGE THROUGH FORWARD

RATES
INTRODUCTION
FORWARD RATE

• A rate which is agreed between the bank and the investor for
buying and selling currencies at a future specified date.

ACTUAL FORWARD RATE (AFR)

• Rate actually quoted by bank for entering into a forward


exchange contract.
• Is equal to forward rate.

FAIR FORWARD RATE (FFR)

• To determine whether the AFR is appropriate or not.


• Helps us to calculate a forward rate that should be prevailing
forward rate,
HOW TO CALCULATE FFR-
AN ILLUSTRATION

• Spot rate : 1$= ₹64


• Interest rate prevailing in India = 12%
• Interest rate prevailing in US = 7%

Determine the FFR in 1 year?


SOLUTION
US INDIA
$1 ₹64
+7% +12%
$1.07 ₹71.68

After 1 year, $1.07 should be equal to ₹71.68.


=>$1.07 = ₹ 71.68
=> $1 = ₹71.68/$1.07
=> $1 = ₹66.99

Thus, one year FFR should be $1= ₹66.99


SOLUTION USING FORMULA
Formula:
S(1 + iL ) 64(1+0.12)
FFR = -------------------- = ----------------------
(1 + iF ) (1+.07)
FFR = ₹66.99

Where,
FFR = Fair forward rate
S = spot rate = ₹64
iL = interest rate (local currency) = 12%
iF = interest rate (foreign currency) = 7%
ARBITRAGE WITH FORWARD CONTRACT

Making Riskless
Profits

Buying currency from one market and selling the


same in another market simultaneously.
STEP1: To determine whether an
arbitrage opportunity exists or not?

To determine whether arbitrage opportunity


exists:
Compute FFR
Compare FFR with AFR.
 If FFR= AFR => No arbitrage opportunity exists.
 If FFR ≠ AFR => Arbitrage opportunity exists.

Thus, arbitrage opportunity arises only when


there is a mismatch between AFR & FFR.
ILLUSTRATION
• Spot rate : 1$= ₹64
• Interest rate prevailing in India = 12%
• Interest rate prevailing in US = 7%
• One year FFR: $1= ₹66.99
• One year AFR: $1= ₹65.90

Does an arbitrage opportunity exists? If


yes, then
a) Explain the arbitrage strategy?
b) Determine the possible arbitrage gain?
SOLUTION
Buy the
The $ is
underpriced
AFR<FFR underpriced in the
currency, i.e $, in
forward market
the forward market

To take a counter position, one has to


sell $ in the spot market.

Arbitrage Sell $ in spot market.


strategy Buy $ in forward market.
Arbitrage Sell $ in spot market.
strategy Buy $ in forward market.

P
How to arrange $ for “sell spot” ?
R
O • Borrow in US $ to arrange $
B
L
What do with ₹ obtained?
E
M • Invest in India with ₹ obtained.
S
Arbitrage Sell $ in spot market.
strategy Buy $ in forward market.

Complementary Borrow in US
strategy Invest in India.

Core steps in arbitrage process:


1. Borrow in US.
2. Sell spot
3. Invest in India.
4. Buy forward.
Borr
• Borrow $1,00,000 in US @7% pa for one
ow
in
year.
US

Sell
• Sell $1,00,000 @ spot rat of $1=₹64.
spot

Inve
st in
• Invest ₹64,00,000 @12%pa for one year
Indi
a

Buy
• Buy forward (1year) $1,07,000 @ $1 =
For
war ₹65.90
d
After one year

Realise investments ₹64,00,000 * 1.12 =


₹71,68,000

Honour the forward contract by paying


₹70,51,300 ($1,07,000 * ₹65.90)

RESULT:
ARBITRAGE GAIN = Inflow-Outflow
Repay the US Loan (with interest)
= ₹71,68,000 – 70,51,300 = ₹1,16,700
from the obtained $1,07,000.

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