The Basics of Investing and Trading

Arbitrage is the process of taking advantage of the mis-pricing securities or a price difference between two or more markets. Suppose that the exchange rates between the Euro, US Dollar and Singapore Dollar are as follows:

EUR -USD – 1.4808(buy), 1.5008(sell)

EUR-SGD – 2.0975(buy), 2.1175(sell)

USD-SGD – 1.4472(buy), 1.4672(sell)

This essentially means that the Foreign Exchange firm (say Thomas Cook or ICICI) will sell 1 EUR for 1.5008 USD and buy 1 EUR for 1.4808 USD and so on…

If I do the following:

1. Buy Euros with 1 million SDG. I would have 1,000,000 /2.1175 = 472,257 EUR

2. Buy USD with my 472,257 EUR. I would have 472,257 * 1.4808 = 699,315 USD

3. Buy SGD with my 699,332 USD. I would have 699,315 * 1.4472 = 1,012,048 SGD

Thus, I would have made a risk-free profit of 12,048 SGD !

Obviously, in this case there is some mis-pricing in the market. These prices are not real prices. The spreads between ” buy and sell ” are generally higher in the real world and the prices are such that there is no scope for this kind of arbitrage. In the previous The EUR-USD rate is higher than it should be.

These kinds of situations are rare.However, they do occur. That is when hedge funds and algorithmic traders take advantage of such mis-pricing to make a risk free profit. The market eventually corrects itself when the prices rise in response to the increased demand, thereby correcting the price differential.

Example of Arbitrage in the day to day world

A certain cookie outlet sells cookies at 77 cents each (for students). Thus, when you order 1 cookie, you are charged 77 cents which is rounded off to 75 cents. However, when you buy 2 cookies, you are charged 77 * 2 = 154 cents. This amount is rounded off to 155 cents i.e $ 1.55

Thus, theoretically speaking, if you place an order for 1 cookie 1000 times, you end up paying 750$. You can package these cookies into pairs of 2 and sell them to subway customers at $1.55 per package thereby earning 1.55*500 = $775 , thus making a profit of 25 $. This is of course, assuming that you don’t get bulk discount and that you can find customers who want to buy packages of 2 cookies and the continuation of the price differential in question.

Ok, I am not suggesting even for a moment that someone should actually go and do this.Rather, I am illustrating the concept of arbitrage.

Before we go on to explore Interest rate swaps, let us get a rough idea of the playing field. Think for a moment that Intel is setting up a bunch of fabrication plants and research labs in China and needs a 1 billion US$ loanfor that purpose. Let us say that it approaches Citibank and asks for a quote on how much interest that it will charge for this loan. For Citibank to lend 1 billion US$ to 1 single customer is a huge risk. No bank would normally take such a huge risk. What if Intel went bankrupt and was unable to pay back the loan amount(principal)?

Therefore, Citibank would normally invite other large Corporate banks to contribute towards this sum of 1 billion dollars.Let us also suppose Citibank calls up Barclays, Credit Suisse, ABN Amro, Royal Bank of Scotland and Deutsche Bank and that these banks express interest in taking part of this loan exercise. Thus, all these banks would jointly come up with the required 1

billion dollars to be lent to Intel. This set of banks is called a syndicate and this type of a loan is called a Syndicated Loan. Normally, a single bank take the lead role in this process and is known as the lead manager.In this case, the lead manager would normally be Citibank which would contribute a large portion of this 1 billion dollars.Needless to say, the interest payments made by Intel would be shared by the syndicate member banks in the ratio in which they contributed to the principal amount ( In this case,1 billion dollars).

Suppose that this syndicate of banks decides that they would charge Intel an annual interest of 8.5% per annum (per year) payable annually. Also suppose that Intel would like to pay back this money(1 billion dollars) over 5 years. Thus, normally Intel would pay the syndicate of banks $85 million every year for the next 5 years. It would then pay back the principal amount of $1 billion(at the end of the 5 year period).

Now suppose that another large bank, say Morgan Stanley tells Intel that it could lead another syndicate and lend Intel the same 1 billion dollars at 8.48%. The difference in interest rates seems to be trivial, doesn’t it? What would be the interest payable to this syndicate by Intel? If you do the number crunching, you would find that the interest payable annually would turn out to be 84.8 million dollars. This is a difference of $200,000 per year which adds up to $ 1 million over 5 years ! Therefore, we can see clearly that we need a better unit to represent interest rates.

To solve this problem, banks normally represent interest rates in terms of a unit known as “basis point”. 1 basis point is 0.01 percent i.e 0.0001 i.e 1/10,000 . Thus, a different of 0.02% in interest rates is a difference of 2 basis points (also known as “pips” in this case). Alright, we have just seen how large corporations borrow from Corporate banks at fixed interest rates. Let us now see what floating rates are. Floating rates, as the term implies, are rates that change on a day to day basis. When banks lend each other money, they charge interest. The rate of interest they charge varies from day to day and is usally pegged to a benchmark rate such as the LIBOR. LIBOR stands for London Inter Bank Offered Rate. This is the rate at which banks in London

lend to each other(And this figure changes on a daily basis). However, this very rate can be used as a benchmark to base floating rate loans, i.e Citibank may lend Intel 1 billion dollars at a floating rate of LIBOR + 50 bases points. Thus, at the end of 1 year, suppose the LIBOR rate is 6.5% per annum, the interest that Intel has to pay is (6.5+0.5) % of $ 1 billion i.e 70 million$. Suppose the LIBOR value at the end of year 2 is 6% p.a, Intel would have to pay only 65 million
dollars as interest for year 2.

When would Intel choose to borrow on a floating rate? Think for a moment, what would happen if the LIBOR rate goes up? Intel would have to pay a higher amount of interest. What would happen if the LIBOR rate falls? Intel would have to pay a lower amount of interest. Thus,generally speaking, a company would choose to borrow on floating rates if it thinks that the interest rates are going to drop.

Moving on to a different example, suppose that Halliburton owes $ 1 billion to a syndicate of banks led by ABN Amro and that the principal amount is repayable after 5 years.Now, assume that the interest is payable annually and the rate is pegged at the 12 month LIBOR + 100 bases points. Suppose the LIBOR rate at the beginning of Year 1 was 5.51%. Thus, Halliburton would have to pay $ 65.1 million at the end of Year 1. Now, if the LIBOR at the beginning of year 2 rose to 6.51%, what would be the interest payable at the end of year 2?

Halliburton would realize at the beginning of Year 2 that it would have to pay 75.1 million dollars as interest at the end of Year 2. Now, if Halliburton felt that interest rates would continue to rise and that it would want to know in advance, the interest that it would have to pay at the end of Years 3,4 and 5 (for better planning and budgeting), it might want to pay interest at a fixed rate every year.

It would then have 2 options. One option would be to tell the syndicate of banks that it does not like the existing loan plan and to tell them to refinance the loan at a fixed rate. The important question here is – “If the banks forsee a rise in interest rates, why on earth would they want to give in to Halliburton’s request to switch to a fixed rate and potentially lose millions of dollars in interest payments?” The answer lies in the fact that banks charge hefty amounts as “refinancing fees”. Moreover, if the banks forsee a sharp rise in interest rates, they would simply quote a higher fixed rate o interest.

Therefore, this option seems like an expensive one for Halliburton, doesn’t it? Moving on to the next option, Halliburton could also go in for an interest rate swap.That is, it could tell a bank(not necessarily a part of the syndicate) or a counterparty, say JP Morgan, that it would pay JPM interest on $ 1 billion at a fixed rate in return for an interest on $1 billion at LIBOR + 100 basis points.JPM would then give Halliburton a quote on what the fixed rate payable to JPM would be,in this case say 7.01%.

In this case, $1 billion is called the notional amount, because the interest rates are calculated based on this amount as principal. Note that the notional amount does not change hands between the two parties (known as counterparties) involved in the swap.

Once Halliburton accepts the deal, it would have to pay JPM a fixed rate, say 7.01% p.a and get interest from JPM at LIBOR + 100 basis points. It would also have to pay the ABN Amro led syndicate at LIBOR + 100 basis points. Thus, the nett amount that flows out of Halliburton’s coffers every year is 70.1 million dollars.

This is an example of a floating to fixed interest rate swap for obvious reasons. Similarly, one could have fixed for floating swaps and fixed for fixed swaps. You might wonder, – “Why on earth would anyone do a fixed for fixed swap?Wouldn’t it obviously mean that one party swaps a higher rate for a lower rate and end up losing money?” Let us move on to the next example to understand what happens in the case of fixed for fixed swaps.

Suppose Reliance Infocomm wants to expand into the European market and needs a 500 million euro loan. Also suppose that the interest rate that Reliance would have to pay is 8% p.a. Now suppose that Lufthansa wants to penetrate the Indian market and needs to buy equipment and set up offices in India and that it needs a loan of 120 crore Indian Rupees (1.2 billion Indian rupees),which it can get only at 9% p.a. Suppose that Lufthansa,being a German carrier, can take loans in Germany at 6% p.a and Reliance,being a well established Indian company, can take loans in India at 8% p.a.

If Lufthansa borrows 500 million euro in Germany at 6% and give it to Reliance(which would then pay interest at 6% p.a instead of 8% p.a) and if Reliance borrows 120 crore Rupees at 8% p.a and gives it to Lufthansa(which would then pay interest at 8% p.a instead of 9% p.a), then both parties would save a lot of money( Lufthansa would save 12 million Rupees per year and Reliance would save 10 million euro per year). This is exactly what both the companies would do – Go in for a Fixed for Fixed swap.

Interest rate swaps are derivatives since they are “derived” from loans and interest rates. They are traded OTC (Over the Counter), which means that no one regulates these deals. Thus, interest rate swaps can be customized to suit the needs of both parties. Interest rate swaps are heavily traded derivates, accounting for a substantial portion of the revenues for many investment banks. For a rough idea of the scale of this trading, the total notional amount of US Dollar Interest swaps in 2004 was close to 40 trillion USD (Source: Wikipedia) ! The Fixed Income desks of Investment Banks generally deal with interest rate swaps.Swaps need not be confined to interest rates or cashflows. One could have Forex swaps,Equity swaps etc, but that is totally different story!