FX forwards during the financial crisis
FX forwards are among the most liquid derivative contracts in the world and often reveal more about the health of money markets (markets for borrowing or lending cash) than published short-term interest rates themselves.
(a) On 3 October 2008, the euro dollar FX rate was trading at €1 = $1.3772, and the forward price for a 3 April 2009 forward contract was $1.3891. Assuming six-month euro interest rates were 5.415%, what is the implied six-month dollar rate? Both interest rates are quoted with act/360 daycount and semi-annual compounding. There are 182 days between 3 October 2008 and 3 April 2009.
(b) Published six-month dollar rates were actually 4.13125%. What arbitrage opportunity existed? What does a potential arbitrageur need to transact to exploit this opportunity?
(c) During the financial crisis, several European commercial banks badly needed to borrow dollar cash, but their only source of funds was euro cash from the European Central Bank (ECB). These banks would: borrow euro cash for six months from the ECB; sell euros/buy dollars in the spot FX market; and sell dollars/buy euros six months forward (to neutralize the FX risk on their euro liability). Explain briefly how these actions may have created the arbitrage opportunity in (b), which existed for several months in late 2008.