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How to take advantage of expected changes in interest rates
If we anticipate a change in interest rates, we are alsa anticipating a change in net accessible interest differentials and, therefare, in the swap rate. We can take advantage 'Of the expected change in rates in either the maney market or in the foreign exchange market. In the maney market, we will simultaneausly barraw and invest in the currency whase interest we are expecting ta change. Hawever, the maturity 'Of the barrawing will be different fram that 'Of the investment. In the fareign exchange market, we have to deal with two currencies. To take advantage of the expected change in swap rates, we will buy and sell each currency simultaneously. However, the maturity of the buy and sell in each currency will be different. Let's illustrate the mechanics 'Of this transaction.
Cansider a case where the interest rate of a currency is expected to decrease. The rates in Exhibit 7.5 summarize the present situation and the forecast. We expect interest rates on the pound will decline by 1 percent within a month, and so will the discaunt an the forward pound. Haw does one take advantage of this piece of intelligence?
Money market. In this market we want to lack in the present high return of 13 percent on placements in pounds. So, we make a placement far, say, six months. To finance this laan we need ta raise funds; hawever, since we expect interest rates to decline in a manth, we shall barraw the funds only for that periad. Assuming that the pound interest rate changes as anticipated, the returns will be zera for the first manth (lending and barrawing costs are the same) and 1 percent p.a. far the remaining five manths (13 percent on the loan less 12 percent borrawing casts).
We can see this maney transactian in terms of cash flaw boxes in Exhibit 7.5. The net gain of the transaction when dealing with £1 millian is £4,167 (£15,000 net inflow in Box C less £10,833 net outflow in Box B). At an exchange rate of $2.40, this amounts to $10,000 profit.
The information from which we are trying to benefit is the expected decline in the discount in the forward pound. We expect that discount to decrease from the present 3 percent to 2 percent. (In our example, this decline is based on the prediction of a decrease of 1 percent in the pound interest rate from 13 percent to 12 percent.) If the discount of a given currency is going to decrease, then, as long as the spot rate remains unchanged, one can say that the forward outright price of that currency is going to increase.
On the basis of basic economic principles, we want to buy when prices are low and sell when prices are high. In this case we will want to buy the forward pound now while the discount is large (the price is relatively low) and sell it later when the discount is smaller. When we deal in the forex market, we have to deal with two currencies.
Therefore, the previous statement can also be read as "sell forward U.S. dollars now at the present high premium and buy them later when the premium against the pound has decreased."
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