If short-term interest rates are higher in one country than in another, the forward market provides a medium by which funds may be transferred from the low to the high market, invested for a period, and brought back again without exchange risk. A credit risk may exist, but normally it is very small. This set of transactions is known as an interest arbitrage. Suppose the New York 90-day money rate (not the exchange rate) is 3 per cent per annum and the 90-day rate in Paris is 2 per cent. A Paris bank could earn 1 per cent per annum if it could transfer funds to New York, but it would be too risky if the exchange rate on Euro 90 days later in New York remains an unknown factor; because if Euro strengthened--i.e., cost more in terms of dollars--the 1 per cent gain in interest. might be wiped out by an exchange loss. If, however, simultaneously with the purchase of 50,000 spot dollars, the Paris banker can sell $50,000 worth of 90-day futures (against Euro, of course) for any rate at which the discount in Euro is less than equivalent to 1 per cent per annum, he eliminates all exchange risk. If the discount on forward dollars is equivalent to 1 per cent discount, or any greater discount, the profit from the interest arbitrage is wiped out, or, more properly, the interest arbitrage will not be undertaken. If the rate on forward dollars is identical to the spot rate, the entire interest differential becomes a profit, less the expenses of the operation.
If, by happy chance, the forward rate on dollars stands at a premium, the interest arbitrager, in addition to the 1 per cent interest rate differential of New York over Paris, will make a profit on the exchange transactions (purchase of spot dollars and sale of the same amount of future dollars at a premium). As the premium on forward dollars increases, the more profitable the arbitrage becomes.
It is easy to see that interest arbitraging is dependent on the forward market and can take place only if forward rates are favorable; but does interest arbitraging have an effect on forward rates? Yes: clearly every interest arbitrage requires (1) a purchase of foreign exchange (sale of the home currency) in the spot market, thus a demand for foreign exchange; (2) a sale of foreign exchange (purchase of the home currency) in the forward market, thus a supply of foreign exchange.
In "normal" times, when a pair of currencies are either solidly for a fairly prolonged period, interest arbitraging will have a tendency to "make the forward margin equal the net differences" between interest rates in the one money center and the other.
Even when there is little or no speculation, this tendency may not work itself out; that is, the forward margin may not be equal to the interest differential. In the first place, the funds available for short-term investment abroad may become exhausted before interest arbitraging produces its expected result. In the second place, if the two currencies are on the gold standard a situation may arise in which forward sales are not necessary and in which, therefore, an interest arbitrage may be completed entirely in the spot market.
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