Module 8 Currency, Commodity, and Government Securities

Chapter 3

Impact of events (Brexit) & Interest Rate Parity

34

M8C3-cartoon

3.1 – Brexit, the event extraordinaire!

I originally planned to dedicate this entire chapter to the USD INR pair, which as you may know is the largest traded currency contract in India. But then, the BREXIT issue happened today and I can’t help writing about it as it has a huge relevance to what we just discussed in the previous chapter – events and their impact on currency pairs.

To give you a sense of what happened, have a look at how the Great Britain Pound (GBP) reacted to the event. It was down a massive 8.64%, which you will eventually realize is a big deal in currencies.

Image 1_GBP_Brexit

The Guardian UK, had this to say about the event –

Image 2_Press note

Here is the article.

My objective here is to simplify Brexit to the best of my knowledge and help you understand why the pound reacted the way it did. Obviously, the bigger agenda here is to help you understand the potential impact of such events on currencies. By doing so, you’ll get a grip on how to summarize global events such as Brexit and understand what kind of impact they could have on currencies.

For the sake of simplicity and brevity, let me bullet point Brexit for you. We start with a bit of history –

  1. After the World War 2, Germany and France debated the idea of forming a union of sorts. The thought process was that if countries traded and did business together, then they are less likely to wage war against each other.
  2. This laid the foundation for forming a bigger union called the ‘European Union’ (EU) with more European countries agreeing to join the EU.
  3. The EU formed a single market of sorts where goods, service, and people moved easily across countries. So much so that the EU decided to have its own currency called the ‘Euro’.
  4. UK, although was a part of the EU, never accepted Euro as their currency. Note there are many other countries in the EU which still have their own currency, example – Switzerland, Chez Republic, Denmark etc.,.
  5. There was a growing debate in UK in the recent times on whether the UK should remain in the EU. Many of UK’s citizens believed that UK was better off outside the union as the rules laid out by the EU commission was more taxing on UK’s citizen than actually benefiting them. In simpler words – they believe they would progress faster and better economically and as a society being outside the EU.
  6. Britain option to exit from the EU was called ‘Brexit’.
  7. The UK decided to formally seek its citizens’ vote on 23rd June 2016, where in the citizen would vote for being in or leaving the EU. This is called a ‘referendum’
  8. The outcome of the referendum was a bit of shocker with the UK actually deciding to opt out of the EU. In fact many in the UK and the world believed that UK would vote to stay in the EU.

The referendum’s outcome sent a shiver down the spine for traders and investors round the globe. The GBP crashed to a 31 year low, the major European indices dove close to 8-10%.

Now why did this happen? Why did the markets fall? What is the connection between Brexit and the currency markets and the work markets?

Now here is where I’m hoping the previous chapter comes to help us J

Recall in the previous chapter we discussed how a strong economy (defied by inflation, interest rates, trade deficit etc) leads to a strong currency.

Given this, think about the UK – clearly UK is one of the strongest economies in the world and contributes significantly the EU. Now with UK opting out of the EU, things are set to change both economically and politically.

While UK has a trade deficit with the rest of the world, it maintains a trade surplus with EU. This should give you a sense of how strongly the UK’s economy is coupled with EU.  With UK opting out of the EU, its finances are certainly going to take a hit.

Further the problem is with clarity. Everyone knows that the economic situation is bound to change, but to what extent is something no one really knows. How will the Bank of England react? Will they cut the rates to near zero?

Uncertainty is one thing that the market despises, and given its nature, Brexit has many. Therefore as a result, the markets cracked.

You as a currency trader should be in a position to study the event and understand some basics. From my experience, sometimes the best trades are set up backed by simple common sense and basic knowledge.

Remember if you had studied the event and arrived at a conclusion to not take on a trade, then that in itself would have been a good trade, as the rule of thumb says “when in confusion, do nothing”.

The point is – when you have events of this magnitude around the corner, it is mandatory for you to know what is happening. Taking on a trade without the perquisite knowledge is equivalent to a blind speculative bet!

So, that’s about Brexit and how events like this can impact the currencies.

Let us move ahead to figure out few other currency concepts.

3.2 – Fairy Trade

Imagine a perfect world, where in you can borrow money at a certain interest rate, invest the borrowed money at a higher rate, and earn the differential in the rates.  Confusing? Let me give you an example to simplify this.

The interest rate in the United Sates is about 0.5%, arguably one of the lowest in the world. Assume you borrow $10,000 from a bank in United Sates at 0.5%; invest this borrowed money in a country like India where the interest rate is about 6-7%.

To do this, you will have to convert the borrowed money (which is in USD), to INR. At today’s conversion rate, a US dollar gets you 67 INR. Therefore $10,000 fetches Rs.670,000/-. We invest the converted money in India at say 7%.

At the end of the invested year, we get back 7% interest plus the initial capital. This would be –

670000 + 670000*(7%)

= 670000 + 46900

= Rs.716,900/-

We convert this money to USD, assume the conversion rate is 67, we get back $10,700. We now have to repay the principle amount plus 0.5% in interest. This would be $10000 plus $50.

So after repaying back $10,050 we get to retain $650, which if you realize is a risk free gain!

If you realize, $650 is the interest rate differential times the borrowed money –

10000*(7%-0.5%)

10000*(6.5%)

650

This is a simple case of arbitrage, quite easy to implement, don’t you think so?

Given this, imagine a situation where you could borrow large amounts of money from US and invest this large amount in India and make pot loads of money year on year right?

Well, sorry to burst the bubble, such trades happen only in fairy tales J. In the world we live in, such easy risk free profits does not exist. Even if it did, it would vanish before even you realize.

However, the bigger question we need to answer is – why is this ‘fairy trade’ not possible?

3.3 – Forward Premia & Interest Rate parity

The problem with the above trade is that there are one too many assumptions, we assumed–

  1. We could borrow unlimited amounts of money in US
  2. We could deposit unlimited amounts of money in India
  3. There is no cost of transaction, no taxes
  4. Easy movement of currency between countries
  5. Most importantly we assumed the conversion rate stayed flat at 67 after 1 year

Given that such arbitrage cannot exist for long, the currency rate a year later should be such that it would prohibit the arbitrage to exist.  In other words,

The money we receive from India a year later = Money we repay to banks in US a year later

From the example we discussed above, we borrowed $10,000 from US, invested the same in India and a year later we received Rs.716,900/-.

For the arbitrage to NOT exist, at the end of 1 year,  Rs.716,900/- should be equal  to $10,050.

This means the conversion rate should be –

716900/10050

= 71.33

This is called the ‘Forward Premia’ in the currency world. The approximate formula to calculate the Forward Premia is –

F = S * ( 1+ Roc * N) / (1 + Rbc * N)

Where,

F = Future Rate

S = Today’s spot rate

N = Period in years

Roc = Interest rate in quotation currency

Rbc = Interest rate in base currency

Let’s apply this formula to check if we get the forward rate right for the above situation. Remember the spot rate is 67,

F = 67*(1+7%*1) / (1+0.5%*1)

= 71.33

Further, note that the forward premia rate is approximately equal to the spot rate plus spot times the difference in interest rate i.e. –

F = S*(1+difference in interest rates)

= 67*(1+ 7% – 0.5%)

= 67*(1+6.5%)

= 71.35

This is called the ‘Interest rate parity’.

Think about this – Indian Rupees is trading at 67 today compared to 71.35 in the future, therefore the Rupee is considered to be at a discount now. Generally speaking, the future value of any currency which has a higher interest rate is at a discount to a currency which has a lower interest rate.

So why are we discussing all this and what is the relevance to currency trading? Well, the forward premia plays an important role in determining the futures price!

We will discuss more on this going forward.


Key takeaways from this chapter

  1. Events like Brexit tend to have extra ordinary influence on currencies
  2. A country whose economy is expected to suffer tends to have a weaker currency
  3. Forward premia is the expected spot rate over a given period
  4. Forward premia = S * ( 1+ Roc * N) / (1 + Rbc * N)
  5. Interest Rate parity indicated that the forward premia is approximately equal to the spot rate plus spot times the difference in interest rate
  6. Future value of any currency which has a higher interest rate is at a discount to a currency which has a lower interest rate

34 comments

  1. garg10may says:

    Nice article waiting for more. I would suggest one thing, please add a form of notification like fb, or a automated email sender, whenever you are replying. I am replying in so many modules and have no idea what you replied. WordPress has extension for that.

  2. arvind sathish says:

    In currency option trading there is no fixed lot size ? and showing qty in 2 ,562, 307 like wise so what is the amount required to trade in currency usdinr option which is showing 0.34 @ 67.5 call option

  3. SARATH says:

    SIR,
    please add more lessons , my currency exam on 12-6-2016 , i completed nism equity derivatives. exam with 75 % mark all credit goes to zerodha varsity…

  4. John Jayasheelan T says:

    Fantastic Article of Forward Premia & Interest Rate parity thank You sir and Thank You fot the Future Price Formula

  5. arvind says:

    am i getting it right ? trading in currency is less risky than trading in equity , indices or commodities & offers better returns ? 🙂

    • Karthik Rangappa says:

      Less risky? Yes, I personally believe so since the volatility is on the lower side. Better returns? I cannot comment on this 🙂

  6. arvind says:

    seems like currency trends within limited range & easy to predict than stocks . it can be better option if play by rules. we can always get out tommorow if i made a loss . is there any catch , hidden charges ? 🙂

    • Karthik Rangappa says:

      Nope, no catch, no hidden charges. If you know your game well, then there is nothing that can stop you. Good luck.

  7. arvind says:

    Thanks Karthik Sir
    right now focusing on USDINR pair. trying to fully understand its swings & effect of different factors playing on it

  8. Rajshri Pawar says:

    Please expedite your presentation on FNO currency trading dollar rupee.

  9. kumar says:

    a correction needed: In the last para “Rupee is considered to be at a discount now” should be “Dollar is considered to be at a discount now”

  10. Prabhav Prashant says:

    “Generally speaking, the future value of any currency which has a higher interest rate is at a discount to a currency which has a lower interest rate.”
    Future value of INR is at a discount to present USD or present INR?

  11. Hina says:

    Sir in the previous chapter you said that when a country’s rate of interest is high the country receives higher FDI and correspondingly its currency value increases. Since India has a higher rate of interest shouldn’t the USD/INR pair value decrease after one year instead of increasing to 71 after 1 year ?

    • Karthik Rangappa says:

      Hina, the rate of interest is just one of the factors. There several other factors which influence the currency pair.

  12. Arun says:

    Hi karthik,
    CAN u plz in ur simple language explain its meaning:::::“Generally speaking, the future value of any currency which has a higher interest rate is at a discount to a currency which has a lower interest rate.”
    thanks.

    • Karthik Rangappa says:

      Basically, if a country offers higher interest rate (risk-free) then the currency strengthens against another country’s currency where the interest rate is lower. This is just one of the factors which influence the currency movement.

  13. Akshay says:

    Hi Karthik,

    If the concept of Forward Premia holds good, keeping all other factors constant, the value of INR should depreciate every year against USD to hold up interest rate parity. But this does not happen, INR has pretty much ranged in 60s against USD for so many years. Why so?

    Thanks,
    Akshay

    • Karthik Rangappa says:

      Akshay, does the forward premia capture all the macro (both economic and geopolitical) factors in play? If the answer is no, then perhaps its a flawed model to begin with.

      • Akshay says:

        So that means that Interest Rate Arbitrage Opportunities do exist?

        • Karthik Rangappa says:

          I suppose so, Akshay.

          • Akshay says:

            Since we discussed that carry trade opportunities do exist and USDINR does not always depreciate linearly at risk free interest rate, does it make sense to short one year future contract (USDINR 19 OCT is trading at 73.23, 18 DEC is at 70.80) with the hope that 1 year future spot rate will be less than 73.23?

          • Karthik Rangappa says:

            Well, from what I hear, the carry trades are losing its sheen. Btw, what you suggest is a straightforward directional trade, you should if you think the INR will gain strength.

  14. Akshay says:

    Hi Karthik,

    Since STT is not applicable on currency futures, is it not more profitable trade than equities?
    Or is there any hidden charge (Income Tax) which will turn the equation?

    Thanks,
    Akshay

  15. Rasik says:

    Hi Karthik,

    I have gone through Interest rate parity formulla.
    What my doubt is as per this formulla if interest rate in India is higher then INR will goes on depriciating ..
    But Interest rate in India will remain always higher India is growing country in which gdp growth likely to remain rate is 7-8 % and so the inflation will remain in this range and so the Interest rates going to be 7-8 % in future .
    Whereaa USA is developed country and interest rate are not going to go up more than 3 %
    So due to this diff will (7- 3 )% in future so does this mean by formulla , that INR will goes on depreciating ?

    • Karthik Rangappa says:

      Not really, remember the strength of the currency also depends on trade outputs, geo political situation, macros etc.

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