1f555Swap Arbitrage MFT NOTES

8/8/2019 1f555Swap Arbitrage MFT NOTES

1/19

SWAP-

ARBITRAGE


2/19

Arbitrage in Spot Market

Bank A and B quote :-

A GBP /USD1.4550/1.4560 1.4538/1.4548

Is there an Arbitrage opportunity?


3/19

YES: there an Arbitrageopportunity

i.e B* *

Bank B *

Buy pound from B at 1.4548 and sellto A at 1.4550.


4/19

How can the bank

remove theArbitrage

opportunity?


5/19

A

GBP /USD 1.4550/1.4560

1.4545/1.4555

Bank will change quote to:-


6/19

e Ban

* *

Bank B

* *

Buy pound from B at 1.4555 andsell to A at 1.4550.Loss.No

Arbitrage.


7/19

SWAPS

Combination of two or more deals.

Spot and fwd simultaneously.

Spot 60 day dollar-euro swap is spotpurchase of dollar and fwd sell of thesame dollar.

Both are fwd then FWD FWD.

Temp X of one currency for other,With obligation to reverse deal forother.


8/19

SWAPS

Amount of base currency same.

Other currency rate in Fwd leg

different due to Premium or Discount.Difference Swap Margin.


9/19

SWAP MARGIN

USD/CHF-1.4265/1.4275.

1 MONTH SWAP-15/8.

Means 0.0015/0.0008,.must be addedto the Spot rates.


10/19

CALCULATION

Actually the forward rate is

USD/CHF-1.4280/1.4283.Less

Spot rate -1.4265/1.4275

We get the swap margin- .0015/.0008

i.e.15/8.


11/19


12/19

PROBLEM

Customer wants 3 month CHF-LIRASwap.

Customer will Sell CHF 1 million spotagainst LIRA.

Buy CHF 1 million 3 month Fwd(?)against LIRA.

Fwd market thin.

Bank will go to Euro-Lira market.


13/19

SOLUTION

Euro-rates:-

CHF/ITL Spot- 755/765.

Euro CHF: 6 6 .Euro LIRA: 15 15 1/2.

What swap margin must the bank

quote?


14/19

Assume Bank has given Swap rate as

CHF/ITL -760.00.

Bank borrows ITL 760 Million at 15 and deliver customer.

Bank receives CHF 1 Million from

customer and invest in deposit at 6%.At maturity after 3 month Bank must

pay:-


15/19

ITL 760(1+ 0.25(0.1550))million=

ITL 789.45 million.

The CHF deposit would have grown to

CHF 1[1+0.25(0.06)]million=CHF 1.015million.

The bank will break even if it charges

(789.45/1.015)=777.78 lira perCHF on thefwd leg of the fwd contract(?).

The bank has thus manufactured a swapquote from the inter bank deposit market.


16/19

PROBLEM - 2

Customer wants 3 month Loan ofDKK 50 Million.

No euro market.Spot USD/DKK-8.5025/35.

3 month Swap- 350/400.

Euro Dollar 3 month rates-8 -8 .What rate of interest should the bankquote on the DKK loan?


17/19

Solution

Suppose bank does Swap at spot rate8.5030.Swap Margin -400 pips.

Thus rate of fwd leg would be DKK8.5430.(8.5030 + .0400)Bank has to borrow $ (50/8.5030)million tobuy and and loan DKK 50 million.On maturity bank has to buy back sameamount of dollar @ DKK 8.5430.It also has to pay on dollar loan :-

$(50/8.5030)[0.25(0.0875)]


18/19

Out right forward USD/DKK-8.5435.

Total amount to be recovered from

customer DKK:-(50/8.5030)[8.5430+(0.25)(0.0875)(8.5435)] million =DKK 51.3342.

i.e. 4*[(51.3342/50)-1]=0.1067=10.67%


19/19

PROCESS

Bank to borrow $ equivalent to 1 mln DKK.

Use spot leg of Swap to convert to DKK.Sell dollar at 8.5030 DKK for every 1 $.

This is also no of dollar required to beborrowed.

Reverse Swap with fwd leg with buy ofdollar at 8.5430 DKK for every Dollar.

Go for outright Fwd to cover risk at8.5435.Pay 8.5435 Dkk for every 1 dollarafter 3 month.

1f555Swap Arbitrage MFT NOTES

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