Please help: How to determine which currency to borrow in covered interest arbitrage.

[levfings]

This has been discussed before..I know. But I am looking for an easy way to remember which currency to borrow when creating an arbitrage for forwards/futures etc.
I know how to determine whether a forward is overvalued or undervalued, but where do you go from there?

 

[dbonder]

1 + RF dometic =? [(1+RF foreign)*(Forward rate)] / Spot price
if left hand side is lower, the rate is low in DC so you want to borrow in the domestic and lend in the higher currency, the foreign. and vice versa.

 

[levfings]

dbonder wrote:
1 + RF dometic =? [(1+RF foreign)*(Forward rate)] / Spot price
if left hand side is lower, the rate is low in DC so you want to borrow in the domestic and lend in the higher currency, the foreign. and vice versa.

What material did you study from? In Schweser, I never thought that made the FC/DC so important. Meaning If something is USD/GBP, to me that means GBP is DC and USD is FC, is that all there is to that?

 

[S2000magician]

levfings wrote:This has been discussed before..I know. But I am looking for an easy way to remember which currency to borrow when creating an arbitrage for forwards/futures etc.
I know how to determine whether a forward is overvalued or undervalued, but where do you go from there?

How do you make money?
Buy cheap, sell dear.
How do you make money in currency arbitrage?
Buy cheap, sell dear.
To buy the cheap currency, borrow the dear currency, then buy the cheap one.
Suppose that BGP is overpriced against the MXN in the forward market. Then GBP is underpriced vs. MXN in the spot market; MXN is overpriced in the spot market.
Borrow MXN, convert to GBP, invest GBP, convert back to MXN, pay off loan, party with profits.

 

[dbonder]

yeah you can replace DC witrh USD and FC with GBP in what i wrote above, no differennce. that formula isn’t in the schweser i dont think but it showed up in the qbank a bunch of times and it works so…

 

[levfings]

S2000magician wrote:

levfings wrote:This has been discussed before..I know. But I am looking for an easy way to remember which currency to borrow when creating an arbitrage for forwards/futures etc.
I know how to determine whether a forward is overvalued or undervalued, but where do you go from there?

How do you make money?
Buy cheap, sell dear.
How do you make money in currency arbitrage?
Buy cheap, sell dear.
To buy the cheap currency, borrow the dear currency, then buy the cheap one.
Suppose that BGP is overpriced against the MXN in the forward market. Then GBP is underpriced vs. MXN in the spot market; MXN is overpriced in the spot market.
Borrow MXN, convert to GBP, invest GBP, convert back to MXN, pay off loan, party with profits.

Sorry, still confused, what is dear? Also what is the FC and what is the DC in a USD/GBP or 1.5GBP/1$USD structure?

 

[levfings]

dbonder wrote:
yeah you can replace DC witrh USD and FC with GBP in what i wrote above, no differennce. that formula isn’t in the schweser i dont think but it showed up in the qbank a bunch of times and it works so…

OKAY - so I thought it was the opposite. So in USD / GBP structure, the USD is Called Price Currency or Domestic Currency, and GBP Is called the Base Currency or Foreign Currency?
I know all the material based on just keep the numerator/denomiator the same. So cant understand how to use your formula. Looks like I will have to, bc it’s just not clicking the other way.

 

[S2000magician]

levfings wrote:

S2000magician wrote:

levfings wrote:This has been discussed before..I know. But I am looking for an easy way to remember which currency to borrow when creating an arbitrage for forwards/futures etc.
I know how to determine whether a forward is overvalued or undervalued, but where do you go from there?

How do you make money?
Buy cheap, sell dear.
How do you make money in currency arbitrage?
Buy cheap, sell dear.
To buy the cheap currency, borrow the dear currency, then buy the cheap one.
Suppose that BGP is overpriced against the MXN in the forward market. Then GBP is underpriced vs. MXN in the spot market; MXN is overpriced in the spot market.
Borrow MXN, convert to GBP, invest GBP, convert back to MXN, pay off loan, party with profits.

Sorry, still confused, what is dear?

²dear adjective \ˈdir\
1 obsolete : noble
2 : highly valued : precious [a dear friend] —often used in a salutation [dear Sir]
3: affectionate, fond
4: high or exorbitant in price : expensive [eggs are very dear just now]
5: heartfelt [our dearest prayers]

levfings wrote:Also what is the FC and what is the DC in a USD/GBP or 1.5GBP/1$USD structure?

You can consider either one to be FC and the other to be DC. Usually CFA Institute gives their formulae assuming that quotations are DC/FC, but they work either way.

 

[Xander086]

Dear means expensive
Btw, I’m digging the “buy low sell high” explanation. Shall try this method out later.

 

[verse214]

You should stop thinking about it in terms of domestic and foreign. Think about it as A/B. Currency A is always in the numerator, currency B is always in the denominator. So 1.3 USD/GBP, USD is A, GBP is B.

 

[levfings]

verse214 wrote:
You should stop thinking about it in terms of domestic and foreign. Think about it as A/B. Currency A is always in the numerator, currency B is always in the denominator. So 1.3 USD/GBP, USD is A, GBP is B.

Lol I thought so too - but then how do you figure out which currency to borrow in the covered interest arbitrage?

 

[S2000magician]

levfings wrote:

verse214 wrote:You should stop thinking about it in terms of domestic and foreign. Think about it as A/B. Currency A is always in the numerator, currency B is always in the denominator. So 1.3 USD/GBP, USD is A, GBP is B.

Lol I thought so too - but then how do you figure out which currency to borrow in the covered interest arbitrage?

I thought we’d gone through this already:
Buy cheap, sell dear.

 

[ryohko]

It’s the same thing as FX carry trade, which is a bet against covered interest rate parity. You borrow the currency whose country has the lower interest rate, that’s your funding currency, and you invest it in the country that has the higher interest rate, which is your investment currency.
The forward adds an additional twist. If the forward is overpriced (per covered interest parity) you sell the forward, if the forward is underpriced, you buy it.
To calculate your profit, you need to calculate the implied interest rate (of the investment currency) per the market price of the forward. your profit is equal to:
(real world interest rate of investment currency - implied interest rate) x notional amount

 

[levfings]

ryohko wrote:
It’s the same thing as FX carry trade, which is a bet against covered interest rate parity. You borrow the currency whose country has the lower interest rate, that’s your funding currency, and you invest it in the country that has the higher interest rate, which is your investment currency.
The forward adds an additional twist. If the forward is overpriced (per covered interest parity) you sell the forward, if the forward is underpriced, you buy it.
To calculate your profit, you need to calculate the implied interest rate (of the investment currency) per the market price of the forward. your profit is equal to:
(real world interest rate of investment currency - implied interest rate) x notional amount

Thanks - confirm please though that under carry trade there is no implied interest rate, its the rate the problem gives us…?

 

[ryohko]

In a carry trade problem the interest rate is given. those are the rates that makes the forward rate what it is.
In this case, the “implied” interest rate is the rate of the investment currency that would make the covered interest rate parity come true given the market rate of the forward. of course it’s the difference between this rate and the real world interest rate what gives you the arb opportunity.

 

[levfings]

Thanks. Schweser did a HORRIBLE job on this. Seriously, i spent 3 hours today on figuring out arbitrage calcs, and schweser did not even explain this,