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Profits we dont understand are more dangerous than losses we do understand. Treasury produces financial benefits for organisations, by saving costs and by enabling the commercial activities of the business.
By contrast, chasing arbitrage profits is usually dangerous folly. Arbitrage is very important to define carefully and understand.
Arbitrage means dealing simultaneously in multiple markets, to exploit a temporary discrepancy in prices, and earn a risk-free profit.
Notice the arbitrage opportunity is both (i) temporary and (ii) risk-free.
When markets are efficient, any short-term discrepancies in prices, giving rise to temporary arbitrage opportunities, are eliminated by the market mechanism.
The resulting market condition of parity is known as the no-arbitrage pricing relationship. At the parity prices, there are no longer any arbitrage opportunities. Benefits and costs are equal. This is the no free lunch principle.
Disastrous unauthorised speculation has often been misrepresented as arbitrage.
Treasurers need to understand arbitrage for two important reasons. We need to identify:
(a) Rogue trading and other breaches of policy, to eliminate them.
(b) Too good to be true propositions, to decline them.
Lets say interest rates in two currencies are:
Our boss asks us, Isnt this a great opportunity to borrow at 1%, deposit at 3%, and earn a risk-free 2% profit: why dont we do it?
Treasurers are often faced with this kind of question. We need an answer.
This is a good way to start answers. It acknowledges the question is half-right. Its certainly true that we could get an interest rate benefit by doing this deal.
Theres also a significant cost to the proposition. Namely, an FX loss.
Wed start the deal by borrowing currency C at 1%, and convert it to currency D at the spot FX rate. Wed simultaneously deposit currency D, to earn the attractive rate of 3%.
At maturity, we need to re-exchange the currencies. To avoid FX risk, wed need to pre-agree a forward FX rate for the re-exchange.
If the market would ever give us a forward contract to re-exchange at the same FX rate as we enjoyed at the start, we could indeed be better off by the interest rate difference of 3% 1% = 2%.
Market prices will normally already have adjusted, via the market mechanism, to eliminate any opportunity for risk-free gains by doing these types of round trip deals.
Therell be an adverse difference between the spot and forward FX rates, resulting in an FX loss. Under parity, we lose exactly as much on the FX difference as we gain on the interest rates.
Having understood this relationship, we need to explain it concisely to others.
Your new colleague has heard you mention arbitrage and interest rate parity, but does not understand what these terms mean.
How would you explain the relationship between arbitrage and interest rate parity?
Arbitrage means dealing simultaneously in related markets whose prices are misaligned, to take advantage of a temporary discrepancy in prices.
Parity is the situation where prices are consistent. Under parity, there are no such risk-free profit (arbitrage) opportunities.
Interest rate parity (IRP) is the expected no-arbitrage price relationship between the interest rates in two currencies, and the spot and forward FX rates.
Most arbitrage opportunities are short lived and small, because the market mechanism acts very quickly to realign market prices.
If IRP did not hold, a related arbitrage opportunity might be to:
exchange it immediately for a second currency;
deposit the second currency at a higher interest rate; and
re-exchange the currencies at a pre-agreed favourable forward FX rate.
In practice, IRP holds very strongly for widely traded currencies, because of the large volumes and speed of dealing, including arbitrage dealing.
Back in the office, hearing or seeing the word arbitrage should alert us to be cautious and ask questions.
Nick Leeson of the former Barings Bank created unauthorised speculative positions, and misreported them as arbitrage to his managers. Leeson concealed the losses on his speculations, and reported fictional profits.
The reported profits were too good to be true. These fictional profits were large, persistent and reportedly risk-free. But no real arbitrage opportunity would have lasted that long. Senior management didnt understand arbitrage well enough. As a result, they didnt ask the right questions. Leesons disastrous speculations lost his employer well over $1bn, and led to Barings failure in 1995.
The message that my name brings is caution. You do need to understand what youre doing, otherwise a lot of people blow up, and blow up very quickly.
The official report into the failure of Barings included the following lessons:
(a) Management has a duty to fully understand the business it manages.
(b) Responsibilities have to be clearly established and communicated.
To fulfil our management responsibilities, we need to understand.
Were these lessons from the Barings failure learned and applied? Evidently not.
Subsequent rogue trading activity resulted in even larger losses, including:
A total of $9bn for those two organisations alone.
Invest study time to understand treasury as deeply as you can. Your organisation needs your insight to prevent the next disaster!
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Registered address : The Association of Corporate Treasurers, 69 Leadenhall Street, London EC3A 2BG, UK.