Question

Please read the article and answer these questions. Thanks. Article: TESTING THE GLOBAL CENTRAL BANK SWAP...

Please read the article and answer these questions. Thanks.

Article:

TESTING THE GLOBAL CENTRAL BANK SWAP NETWORK

In the last few weeks, the ECB has been drawing on its liquidity swap line with the Fed, first $308 million for a week, then $658 million for a week, and last week back down to $358 million. What’s that about?

It’s not such a large amount. Bank of Japan borrowed more in the past, $810 million in March and $1528 million in January. But the question then repeats, what was that about?

Both of these drawings are part of the new set of central bank swap lines linking what I call the C6: the Fed, ECB, Bank of Japan, Bank of England, Swiss National Bank, and Bank of Canada. On October 31, 2013these lines were made permanent and unlimited; contract details may be found here. Ever since then I have had a slide in my powerpoints saying “Forget the G7, Watch the C6.”

So now we’re watching. What are we seeing?

Central bank swaps are in some ways quite similar to a standard commercial FX swap, but the differences are important and significant.

A standard swap involves exchange of two currencies today at the spot exchange rate prevailing today, plus a promise to reverse the transaction at maturity using the forward exchange rate prevailing today. Suppose that forward rate is calculated using covered interest parity as

F = S(1+r)/(1+r*)

where r and r* are respectively the dollar and foreign interest rate for a given term T, s is the spot exchange rate and f is the forward exchange rate for date T.

In this case, the exposure of the standard swap contract is identical to a swap of IOUs between the contracting parties at the prevailing interest rates in their respective currencies. One party borrows dollars at rate r and the other party borrows euros at the rate r*.

Central bank swaps are different. First, the forward rate in the contract is usually exactly the same as the current spot exchange rate. This means that central banks are never in the position of realizing profits or losses from the swap (although of course there will be implicit profits and losses), that come from deviation between the agreed forward rate and the spot rate at expiry.

Second, the interest rate on the contract is negotiated rather than calculated from market prices. But, given the choice of forward rate, the analogous commercial contract would call for payment of the interest differential, so anything different from that is significant. Significantly, the documentation of the current C6 swap line leaves open the question of who pays interest to who, and how much.

Usual practice has been for the party who draws on the line to pay interest on the line at some penalty rate. Thus the May 9, 2010 swap agreement between the Fed and ECB called for the ECB to pay the USD Overnight Index Swap Rate plus 100 basis points on its dollar borrowing, and the Fed to pay nothing on its euro borrowing. In effect, the ECB was simply borrowing dollars at the discount window, like any other bank, but with its own monetary liability serving as collateral instead of some financial asset.

This kind of arrangement is still in effect a swap of IOUs but at a price that is away from the market. Central bank swap lines thus in effect operate as a kind of outside spread providing bounds within which normal commercial dealing takes place. So long as prices stay at or near CIP, private agents prefer to do business directly with each other. But when CIP comes under pressure, because of one-sided liquidity flows, the central bank moves from backstop to market-maker and the outside price becomes the market price.

The ECB is borrowing dollars from the Fed and lending them on to banks in Europe who have dollar liquidity needs. Here is the tender documentation. Presumably it is doing this for banks who are unable, for whatever reason, to access dollar funding in the open market, or only at a premium that is higher than the ECB charges.

During the financial crisis, dollar funding needs like this got met by central bank liquidity swaps that rose almost to $600 billion, raising questions in Congress. Now, in normal times, smaller sums are becoming a routine way of handling the normal stresses and strains of world funding flows.

For lack of a world central bank, we have a network of central bank liquidity swaps.

(Council on Foreign Relations has a fun interactive app that shows the rest of the emerging swap network as well.)

Questions:

1. A standard foreign exchange swap involves combining a spot contract and a forward contract. Explain the distinction between a spot FX contract and a forward FX contract, and the way in which they can be combined to form a foreign exchange swap.

2. Forward rates in standard swaps are set relative to spot rates to eliminate arbitrage opportunities. Using a numerical example, demonstrate that an arbitrage opportunity would exist if a forward exchange rate quote differed from the formula given in Mehrling’s article.

3. How do swap lines between central banks differ from standard foreign exchange swap contracts? How are forward rates set? How are interest rates determined?

4. Why would a commercial bank borrow foreign currency from its own central bank, rather than using a foreign exchange swap for the purpose?

Homework Answers

Answer #1

Answer to Q1:

Lets first understand the FX contract- this means entering into a contract to buy foreign currency against our own currency. The difference between spot & forward is, Spot is now or technically within next two days to enter into that contact which means the current FX rate is used; whereas for forward we entger into a contact now but the FX rate used will be determined in future date specified now.

So technicallly at the start of the contract in order to ensure both the parties should be treated equally, the Present value of the Spot & forward contract should be equal i.e.

PV of Spot Leg = PV of Forward Leg

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
When the foreign exchange (FX) futures market is used for price discovery: One will generally not...
When the foreign exchange (FX) futures market is used for price discovery: One will generally not see steadily appreciating or depreciating pricing patterns, with price discovery occurring on contract expiration dates in the FX market. FX forward prices are subjective predictors of future spot exchange rates. The pattern of the prices of these contracts provides information as to the market’s current belief about the relative future value of one currency versus another at the scheduled expiration dates of the contracts....
QUESTION 19 When a commercial bank repurchases its security from the Central Bank, the commercial bank's...
QUESTION 19 When a commercial bank repurchases its security from the Central Bank, the commercial bank's reserves _____________ and the Central Bank's assets _________. A. decrease; increase B. increase; decrease C. decrease; decrease D. decrease; remains unchanged E. increase; increase QUESTION 20 Which of the following assets is NOT currently accepted by the Reserve Bank of Australia as a collateral for a repo? A. Bank-issued securities B. Treasury securities C. RMBS D. Non-bank corporate securities E. ABCP QUESTION 21 Which...
Currency Swap Pricing On August 15th, 2013, ABC bank negotiated a 2-year currency swap with TRI...
Currency Swap Pricing On August 15th, 2013, ABC bank negotiated a 2-year currency swap with TRI Corp., paying Euro fixed and receiving USD floating with a notional principal of $100 million. The semi-annual settlement is on every February 15 and August 15 until maturity. The spot FX rate on 8/15/2013 is $1.33 per €1.00. The term structure of interest rates on 8/15/2013 are in the table below. The day count method used is 30/360. A. What is the notional principal...
2.           To your surprise, Nicholas Madura has appointed you as head of the central bank...
2.           To your surprise, Nicholas Madura has appointed you as head of the central bank of Venezuela. Currently Venezuela has the highest interest rates and inflation in the world. Your mission is to reduce inflation and interest rates. You consider three options – reduce money growth but keep a floating exchange rate. Second, fix the exchange rate to the dollar but keep the Venezuelan currency. Third, form a currency board where all Venezuelan currency is backed by foreign reserves...
Answer the following questions and give an explanation of WHY you selected that answer. Please type...
Answer the following questions and give an explanation of WHY you selected that answer. Please type the answers. 1. If a U.S. firm desires to avoid the risk from exchange rate fluctuations, and it will need C$200,000 in 90 days to make payment on imports from Canada, it could: A - Obtain a 90-day forward purchase contract on Canadian dollars. B - Sell Canadian dollars 90 days from now at the spot rate. 2 - In general, when speculating on...
“Like its peers in Denmark, the euro area, Sweden and Switzerland, the Bank of Japan will...
“Like its peers in Denmark, the euro area, Sweden and Switzerland, the Bank of Japan will charge commercial banks for holding deposits with it. Almost a quarter of the world’s GDP now comes from countries with negative rates. Though they defy convention, they have proved a useful addition to the central-banking toolkit. The lowest deposit rate set by the central bank acts as a floor for short-term interest rates in money markets and for borrowing rates generally. Borrowing costs across...
true or false ? 1) Since the global financial crisis of 2008-2009, the Chinese renminbi (yuan)...
true or false ? 1) Since the global financial crisis of 2008-2009, the Chinese renminbi (yuan) has become the most widely traded currency with the U.S. dollar surpassing the euro, yen, and pound as dollar trading pairs. 2) Swap and forward transactions account for an insignificant portion of the foreign exchange market. 3) The European and American terms for foreign currency exchange are square roots of one another. 4) When the cross rate for currencies offered by two banks differs...
8)Carlton, an AAA rated corporate, enters an interest rate swap on $1,000,000, paying Libor and receiving...
8)Carlton, an AAA rated corporate, enters an interest rate swap on $1,000,000, paying Libor and receiving a fixed rate of 2.56% annually. The swap is going to last for 4 years. Currently the 4-year Libor is 2.59% on dollars. One year later, Carlton decides to unwind the swap. What is the NPV of the swap if the three-year interest rate(Libor) is 3.02% now? Who pays whom? Select one: a.-$13,006.61; Carlton pays dealer b.$855; Dealer pays Carlton c.$13,006.61; Dealer pays Carlton...
The interest rate charged by the central bank when it makes loans to commercial banks is...
The interest rate charged by the central bank when it makes loans to commercial banks is called the Select one: a. reserve requirement. b. prime rate c. discount rate d. open market rate. A bank is more likely to face bank runs by depositors if it Select one: a. is solvent. b. if it thoroughly evaluate risks before lending. c. keeps more of its money it reserves. d. makes risky loans to investors. A contractionary monetary policy reduces GDP by...
Use the data table to answer questions 9, 10, and 11: EURUSD Spot Quotes Bank Bid...
Use the data table to answer questions 9, 10, and 11: EURUSD Spot Quotes Bank Bid Ask Citibank 1.1930 1.1935 HSBC 1.1935 1.1940 JP Morgan Chase 1.1925 1.1930 EUR/USD 6-month Forward Quotes Bank Bid Ask Barclays Bank 1.1870 1.1875 Royal Bank of Canada 1.1900 1.1905 6-month Interest Rates (annualized - simple interest) Bank Currency Interest Rate Bank of America U.S. Dollar 0.50% Deutsche Bank Euro 1.50% 10) Assume that you are a U.S. corporation and need to buy EUR 3,000,000...
ADVERTISEMENT
Need Online Homework Help?

Get Answers For Free
Most questions answered within 1 hours.

Ask a Question
ADVERTISEMENT