BORROWING AND INVESTING WITH AN EXCHANGE POSITION
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BORROWING AND INVESTING WITH AN EXCHANGE POSITION
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By:
justinlanger
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We have shown in preceding discussions that any premium or discount on the forward exchange rate (the swap rate) is a function of the net accessible interest differential between the two currencies. If the market is in equilibrium, which it will be if arbitrageurs are allowed to operate, the net yield on borrowings and investments on a covered basis is the same for all currencies. The currency with high 'interest rates will be selling at a discount in the forward market; the currency with low interest rates will be selling at a premium in the forward market. What is gained by investing in the high-interest-rate currency is lost through the discount in the forward market when the investment is covered. What is lost in interest income when investing in the low-interest-rate currency is gained as exchange income in the forward market when the investment is covered.1
With a market that is in equilibrium, the financial officer can obtain a lower cost for borrowings or a higher return on investments only if the borrowings and investments are not covered in the forward market. Of course, the opportunity of reducing borrowing costs or increasing returns on excess funds is achieved only at the risk of experiencing losses which would not occur if the operation were done on a covered basis. The effective yield of a transaction on an uncovered basis is not known until the transaction is ended and the final spot rate is taken into account.
The interest differential is 4 percent in favor of the dollar. In the forward market, the six-month swap rate of SwFO.0520/$ represents a 4 percent per annum discount on the dollar against the Swiss franc. The forex market is in equilibrium. Under these conditions, the financial manager is indifferent as to which currency to borrow or invest in on a covered basis. Converting Swiss francs into dollars to take advantage of the 7 percent interest rate on dollars yields only 3 percent when the 4 percent discount on the forward dollars against Swiss francs is taken into account. Likewise, borrowing in Swiss francs to benefit from the low 3 percent interest rate on that currency will cost as much as 7 percent when the 4 percent premium on the forward Swiss franc against the dollar is taken into account.
At times, the funds manager may be willing to take calculated risks to reduce the cost of borrowings or increase the return on investments. For example, in the scenario of Exhibit 9.4, the funds manager may choose to borrow Swiss francs for six months at 3 percent, even though the funds are needed in U.S. dollars. To have a chance of benefiting from the lower interest rate, the transaction is not covered; that is, Swiss francs are not purchased in the forward market. If the transaction were covered, the 4 percent premium on Swiss francs would make the cost of francs equal to the cost of U.S. dollars at 7 percent. If the spot rate of the Swiss franc against the dollar remains at SwF2.60/$, the manager would have saved 4 percent per annum on the borrowings. On the other hand, if the Swiss franc appreciates substantially against the dollar, the total cost of the borrowings, including the exchange loss, may be more than the alternative cost of 7 percent per annum on dollars.
If, at the end of three months, the Swiss franc has appreciated to Although the interest rate is only 3 percent per annum, the Swiss franc has appreciated at a rate of 4.62 percent per annum. Since the alternative for the funds manager was to borrow U.S. dollars at 7.00 percent, borrowing Swiss francs and running an exchange risk cost the officer an extra 0.62 percent per annum.
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