interest rate hike hitting FX rate

I feel in most major economies the central bank manages interest rate which directly affects FX rate. FX rate doesn't affect interest rate, not directly.

http://www.investopedia.com/articles/basics/04/050704.asp — higher interest rates attract foreign capital and cause the currency to appreciate.

http://www.economicshelp.org/macroeconomics/exchangerate/factors-influencing/ — Higher interest rates cause an appreciation.

http://fxtrade.oanda.com/learn/top-5-factors-that-affect-exchange-rates – When interest rates go up, so do yields for assets denominated in that currency; this leads to increased demand by investors and causes an increase in the value of the currency in question.

Rate hike leads to inflation, which hurts the currency in question?

Rate hike hurts corporations (including exporters) and balance of payment. Would hurt the currency in question? I doubt it.

Fed rate hike is carefully managed based on growth data. Therefore, rate hike is conditional on US recovery, which means stronger USD.

Economic growth could also mean reduced government bond issue i.e. reduced QE, i.e. slower national debt growth which helps the USD.

equivalent FX trades, succinctly

The equivalence among FX trades can be confusing to some. I feel there are only 2 common scenarios:

1) Buying usdjpy is equivalent to selling jpyusd.
2) Buying usdjpy call is equivalent to buying jpyusd put.

However, buying a fx option is never equivalent to selling an fx option. The seller wants (implied) vol to drop, whereas the buyer wants it to increase.

Q: fxo premium as percentage of notional – mismatch!

There’s an illustration in Tony’s lecture notes and also in the homework — 3 month 1.10 EUR call USD put, with Spot = 1.07
Assume the premium = 0.0200, given in USD per EUR
Then pnumccy = 0.0200, or a trader might say “200 USD pips”
”USD %” would be 0.0200/1.10 = 1.82%, pnumccy% = 0.0182
”EUR pips” would be 0.0182/1.07 = 0.0170 or “170 EUR pips”
”EUR %” would be 0.0200/1.07 = 1.87%, pbaseccy% = 0.0187

Observation — last line 1.87% means the premium is 1.87% of the EUR notional; the 1.82% means the same premium is 1.82% of the USD notional.

The paradox — the same premium is 1.87% of the EUR notional but only 1.82% of the USD notional !

(In general, paradoxes provide “aha” moments and great learning opportunity.)

Analysis (thin->thick->thin):

Key — the USD notional and EUR notional can have (vastly) different values before maturity.

Let’s focus on OTM (more common). Without loss of generality, let’s consider deep OTM. In such a case the EUR notional is almost worthless and the USD notional is a king’s ransom.

Naturally, the premium as percentage of the ransom is tiny.

fwd-starting fx swap points

Q: If 9M outright fwd point is 15.2 pips, and 3M is 5 pips, what would be the fwd-starting swap point?

A: The swap point would be 15.2 – 5 = 10.2 pips.
 

The fwd point for a 3Mo (our near date) is F – S = S (1 + R * 90/360)/(1 + r * 90/360) – S, which already considers the 3Mo length.

This formula shows the
* near date fwd point number is linear with (R – r).
* far date fwd point number is linear with (R – r).

However, the linear factors in these 2 cases are Different so it’s completely wrong to subtract like 12 – 5 basis points. Swap point reflects not only the IR differential, but also the “distance” and the spot level.

The swap points are smaller when the distance is short.

Suppose you as market take has an existing 3M fwd position and need to roll it forward. You effectively need to close the position for the original maturity and redo it at 9M. That’s 2 transactions with 2 dealers — unwise. Instead, You should go to one dealer to get a fwd-starting swap quote in bid/ask, without revealing your direction. The dealer would charge bid/ask only on the far leg, not twice on near leg and far leg.
Specifically, If there’s a bid/ask on the 3M fwd point (1.2 pip for eg), that doesn’t increase the swap point bid/ask spread, which would be the same bid/ask spread as the far leg fwd points.

-ve fwd points => ccy1 weakening => ccy1 higher inflation

(As we get older we rely increasingly on intuition)

Tony shared this quick intuition :
* when we see a …negative fwd point, we know ccy1 is …weakening due to … higher inflation in that country, such as AUD or BRL
* when we see a positive fwd point, we know ccy1 is strengthening due to ultra-low inflation such as EUR.

(Note the lowest inflation currency, JPY, is never a first currency…)

Remember ccy1ccy2 = 108.21 indicates the “strength of cc1”

– When we see ccy1 IR lower than ccy2, we know ccy1 will strengthen. You can imagine hyper-inflation in ccy2
– When we see ccy1 IR higher than ccy2, we know ccy1 will weaken. You can imagine hyper-inflation in ccy1

CIP ^ UIP, based on Mark Hendricks notes

Without loss of generality, Let’s suppose the loan period is “today + 12M”.

CIP (not UIP) is enforced by arbitrage and proven by real data. UIP is kind of naive theory, inconsistent with real data.

CIP relates 4 currently observed prices including a fwd exchange rate 12M forward (something like a rate lock). See http://bigblog.tanbin.com/2012/08/fx-fwd-arbitrage-4-ba-spreads-to.html

UIP relates 3 currently observed prices + a yet-unknown price —

E[spot rate 12M later] ) / spot rate = IntRate1/IntRrate2

Above expectation is in _physical_ measure i.e. wishful thinking (IMHO). CIP replaces that expectation with the risk-neutral E*[spot rate 12M later] := fwd contract price today.

RN basically means “backing out the forward contract’s valuation using live market data”. This back-out price is enforced by CIP arbitrage.

CIP arbitrage involves 4 trades done simultaneously. UIP can also involve several trades, but one of them is executed _12_M_ later, so the execution price is unknown now and could lose money.