Fx Swap and Locational Arbitrage
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1. An investor wishes to buy euros spot (at $0.9080) and sell euros forward for 180 days (at $0.9146).
a. What is the swap rate on euros?
b. What is the forward premium or discount on 180-day euros?
2. Suppose the euro is quoted at 0.7064-80 in London and the pound sterling is quoted at 1.6244-59 in Frankfurt.
a. Is there a profitable arbitrage situation? Describe it.
b. Compute the percentage bid-ask spreads on the pound and euro.
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Solution Summary
This solution provides calculations for the swap rate, forward premium, the arbitrage opportunity (calculated in two ways) and the bid-ask spread.
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1. An investor wishes to buy euros spot (at $0.9080) and sell euros forward for 180 days (at $0.9146).
a. What is the swap rate on euros?
In a FX Swap there is an agreement to exchange currencies at the spot rate and then re-exchange the currencies at a forward rate.
"""Swap rate is the difference, whether positive or negative, between the forward exchange rate and the spot rate for a given currency, usually expressed in points.""
Source (http://www.investorwords.com/5815/swap_rate.html)
"
Forward rate on euros= $0.9146 /Euro
Spot rate on euros= $0.9080 /Euro
Swap rate = Forward rate - Spot rate
Swap rate= 0.0066 = 0.9146 - 0.908
Since selling rate (forward rate) is more than the buying rate (spot rate) , there is a premium
A foreign exchange rate is expressed with an integer part and 4 decimal points (some cases 2 decimal points such as for dollar-Yen rates)
The last decimal point (0.0001) is called a basis point or pip.
Thus there is a premium of 66 pips or points (66 x $ 0.0001)
Answer: Swap rate on Euros= 66 pips
b. What is the forward premium or discount on 180- day euros?
When the forward rate is greater than the spot rate, the quoted currency (currency in the denominator) is at a premium.
Premium/ Discount are annualized by multiplying the rate obtained by 360 / n where n is the ...
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