Forum Archive Index - June 2002

["tennyson@caverock.net.nz" <tennyson@caverock.net.nz>]

Hi trader 100,

>
> 
>I thought I'd have a crack at some of the issues you raise.
> 
>The counterparty to a NZ Company Hedge will invariably be a bank. 
>In the case of a forward contract we a talking about an agreement to
>buy / sell currency at a future date at a price agreed on today
>where the price is simply spot +/- an interest adjustment.  For a NZ
>importer (ie a NZD/USD seller) the forward points are negative
>because NZ interest rates are higher than US interest rates.  If it
>wants to hedge using a forward contract one year out it will
>approach a bank and enter into an agreement to sell NZD to the bank
>in one year (and receive USD). No funds change hands between the two
>at this point.  However, the bank won't want to take the risk of
>having to deliver USD in one years time at a rate that could
>potentially be worse than the prevailing spot rate so it will
>purchase the USD on the day the forward contract is arranged.  The
>trouble is the USD it is holding on its counterparties behalf for a
>year are only earning say 1.75% interest while the NZD it just
>swapped for the USD could have earned say 5.5% interest.  The bank
>needs to be compensated for this so the forward rate is less than
>the current spot rate by an amount exactly equal to the interest
>differential.  
>
>



Thanks for this information 'trader 100'.  Now I'll try and work 
through an example to see if I understand what you are saying.

Let's say I want to import $NZ100,000 worth of goods from the US and 
I negotiate that I will hand over the money to my US supplier in one 
years time.

If I had the $NZ100,000 myself today, I could either put it in a New 
Zealand bank and earn 5.5% on it ($NZ5500), or buy the $US today in 
which case I would only earn 1.75%, (or $NZ1750) on that money.  If I 
put that money over to the USA today I would be $NZ5500-$NZ1750= 
$NZ3750 (or 3.75%) out of pocket.   

However, by taking out a one year hedge contract I am asking the bank 
to take this 3.75% loss.   There is clearly no reason why the bank 
will be philanthropic towards me and do so.  So the bank will get 
this lost interest back off me by charging me 3.75% extra when I sell 
my New Zealand dollars and buy US dollars in a years time by fixing 
the exchange rate one year out 3.75% in their favour.

If I did the transaction today then for every New Zealand dollar I 
would get US 47c.   In one years time the bank will do this 
transaction for me but at an exchange rate of:

US47c - (0.0375x47) =US 45.2375c

So for every New Zealand Dollar I will be using to purchase those $US 
in one years time, this means the the bank will be giving me only 
45.24c, not 47c.  The reduced amount of $US I will be getting for my 
kiwi dollars is in compensation for the bank taking an actual 
interest rate loss (due to the bank having purchase the USD on the 
day the forward contract is arranged) over that same period. 

>
>
>Note that the NZ Company could have achieved the same
>result by borrowing USD and holding them for a year.  Because of
>this ability to arbitrage the forward points will always be equal to
>the interest differential.
> 
>

The thing that concerns me about all this is that it seems very 
'theoretical'.   There is assumed to be a relationship between the 
way exchange rate levels move relative to each other and the interest 
rates offered.  But what if this doesn't hold?   Suppose the ANZ bank 
economists are right and the level of the dollar really depends upon 
capital inflows and outflows?    This means the banks may be getting 
into hedge contracts in good faith, thinking they are compenasting 
each party to the hedge contract for their risks, when they are not.  

Anyone got any comments on that?

SNOOPY


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