EXPORTACIONES CHILENAS POR PRINCIPALES MERCADOS DE DESTINO, 1991 - 2001

At this point, it is worth pausing for a moment to adopt a slightly different perspect- ive on the arbitrage process discussed in this chapter so far. Let us go back to the example in Table 3.2. The UK and US interest rates are 5% and 6% respectively and the exchange rate is expected to change from $1 = £0.50 to $1 = £0.60 over the next 12 months. In each of our hypothetical scenarios, the individual was assumed to have a sum of money in pounds (in fact, just £1) available for investment. While this sim- plification may have helped to make the process easier to understand, it also had the effect of making the power of arbitrage mechanisms appear weaker than it actually is. Suppose our hypothetical investor had no money available for deposit either in the UK or USA. Does this rule out the possibility of profiting from arbitrage? Plainly, no. As long as the investor can borrow pounds, he can exploit any opportunities

f F S . . . ≡ − =1 0 60− = 0 50 1 0 2 F S ≡ +1 f

3.3 Borrowing and lending 93

Table 3.5 Uncovered interest rate arbitrage with borrowing

UK strategy US strategy

Action Yield Action Yield

1 January

12-month interest rate 5% 6%

Borrow £1.00 Borrow £1.00

Position taken short sterling short sterling

(£1.00) (£1.00)

Buy $ @ £0.50 each $2.00

Place on deposit £1.00 Place on deposit $2.00

i.e. lend i.e. lend

Position taken long sterling (£1.00) long dollars ($2.00)

Net position during year nil (short £1.00) (long −− short == 0) (long $2.00) 31 December

Liquidate deposit £1.05 Liquidate deposit $2.12

Convert back to £

Sell $ @ £0.60 each £1.27

Repay loan £1.05 Repay loan £1.05

Net profit £0.00 £0.22

offered by deviations from interest rate parity. To see how, go back to the numerical example illustrated in Table 3.2 and rework the calculations on the assumption that the investor borrows £1 on 1 January.

The result is that making a deposit in the USA generates a profit of £0.22 per £1 borrowed, whereas the UK deposit simply breaks even (remember we are ignoring transaction costs both for borrowing and lending and for currency conversion). This outcome should come as no surprise. It is clearly no more than would have been expected from the computations in Table 3.2.

For present purposes, however, it is useful to view the process in terms of the investor’s asset position in each currency, which is precisely what has been presented in Table 3.5.

As far as the first step is concerned, in borrowing pounds the investor deliberately incurs a liability in sterling. Currency market jargon is helpful here:

An investor who has a liability (an asset) denominated in a specific currency is said to have a short (long) position in that currency. So the investor starts by taking a short position in sterling.

Now, as far as the UK strategy is concerned, depositing the proceeds of the loan creates an asset denominated in pounds too, that is, a long position in sterling of exactly £1. The net effect is to leave the investor with a balanced position in pounds.

Moreover, this net zero balance is maintained throughout the year, as the value of the long position increases with the accumulating interest on the deposit and the size of the debt simultaneously rises at the same rate.

By contrast, the US strategy involves converting the £1 to dollars and depositing it in the USA, thus creating a long position in dollars. Now while it is true that initially, on 1 January, the two positions offset one another – the investor’s long position in dollars and short in sterling are both valued at exactly £1 – the situation of exact balance will not be sustained. If the dollar weakens in February, say, the value of the investor’s dollar holding will decline while the sterling debt increases.

In other words, the risk associated with the uncovered arbitrage transaction arises from changes in the net position as exchange rate fluctuations alter the value of the position in the two currencies. The problem never arises in the case of the UK strat- egy because the two positions – borrowing and lending, short and long in pounds – are perfectly matched. Any change in the value of the pound will have offsetting effects on the value of the short and long positions respectively.

Here, we are assuming the exchange rate ends the year at $1 = £0.60, which means the value of the long position in dollars appreciates to £1.27 by the time it is liquidated, while the short position has risen as a result of accumulated interest on the borrowing to only £1.05, leaving a net profit of £0.22.

Before going on to look at covered interest rate parity from this perspective, there are a number of lessons to be drawn from the computations in Table 3.5:

(1) It pays to borrow (be short in) a depreciating currency and lend (be long in) an appreciating currency.9

(2) Since speculation can be achieved by an agent who actually owns no sterling, UIRP does not need to rely on the existence of UK depositors with international perspectives and an inexhaustible supply of funds. In fact, the representative investor/arbitrageur need be neither a UK nor a US resident. Typically, in fact, the agent in question will be a multinational financial institution based in London or New York or one of the major currency trading centres of continental Europe or the Pacific Basin.

(3) Currency risk arises whenever an investor’s net position in a currency is non- zero. When a long position is matched by an equal and opposite short position in the same currency, the investor is said to have a (fully) hedged or covered position in the currency.

Consider hedging the arbitrage in the present example. We saw in the last section that this can be achieved by the simple expedient of selling the dollar proceeds of the US deposit on the forward market on 1 January. The impact on the investor’s asset position is traced out in Table 3.6.

The otherwise unbalanced position at the start of the year, which introduced the element of risk into the US strategy, disappears, because the investor who covers in the forward market has zero net exposure throughout the year. This outcome is achieved as a result of the fact that the forward contract can be viewed as involving two simultaneous transactions: a claim against the counterparty to collect pounds (hence, a long position in sterling) and a commitment to deliver dollars (a short pos- ition in dollars). Together, the two transactions undertaken in signing the forward 94 Chapter 3 · Financial markets in the open economy

3.3 Borrowing and lending 95

Table 3.6 Covered interest rate arbitrage with borrowing

UK strategy US strategy

Action Yield Action Yield

1 January

12-month interest rate 5% 6%

Borrow £1.00 Borrow £1.00

Position taken short sterling short sterling

(£1.00) (£1.00)

Buy $ @ £0.50 each $2.00

Place on deposit £1.00 Place on deposit $2.00

i.e. lend i.e. lend

Position taken long sterling (£1.00) long dollars ($2.00)

Sell $/buy £ forward

@ $1.00 = £0.60 $0.60

Position taken long sterling (£1.00)

short dollars ($2.00)

Net position during year nil nil

(long −− short == 0) (long −− short == 0) 31 December

Liquidate deposit £1.05 Liquidate deposit $2.12

Sell $ @ £0.60 each £1.27

Repay loan £1.05 Repay loan £1.05

Net profit £0.00 £0.22

contract offset precisely the initial short position in pounds and long in dollars that arose when the investor borrowed sterling to deposit in the USA. We can therefore add the following conclusions to those we have already deduced in this section:

A forward sale of x dollars against y pounds (a forward purchase of y pounds with x dollars) is equivalent to lending (being long in) the present value of y pounds and borrowing (being short in) the pre- sent value of x dollars.10

Viewed from this point of view, the CIRP relationship between spot and forward exchange rates and interest rates is less surprising. The commitment to exchanging future claims (borrowing and lending) in the two currencies via the forward market must result in the same payoff as exchanging current claims in the spot market. Hence, any difference in the exchange rate at which the two transactions occur must reflect differences in the interest rates on the two currencies.

Putting the matter in hedging terms, the proceeds of the dollar deposit could be hedged without recourse to the forward market by borrowing $2 at the start of the

96 Chapter 3 · Financial markets in the open economy

year, converting to sterling on the spot and leaving the £1 on deposit for 12 months. At the end of December, the £1 will have grown to £1.05 – just enough to repay the initial loan – and the $2 borrowing on which $2.12 will be owed can be repaid from the original deposit in the USA.

Clearly, however, what is being described here involves no more than putting the original borrowing/lending mix into reverse, thereby unwinding the original position so as to eliminate the risk. It so happens the type of exchange of claims described here is very common in currency markets, under the following guise:

A (plain) currency swap deal involves two parties in the exchange of principal and interest payments on a loan in one currency for prin- cipal and interest payments in another currency.11