Impact of Brexit on Currency Markets and Interest Rate Parity

To get a better understanding of Brexit, let us have a look at the historical context. Here are some key points to consider:

1.     Following the conclusion of World War 2, Germany and France discussed the possibility of forming a union to encourage trading and commerce between them. This was seen as a way to prevent future conflict.
2.     This established the groundwork for creating a larger confederation known as the ‘European Union’ (EU), with more European countries agreeing to become part of it.
3.     The EU created a single market in which goods, services, and individuals could move freely between countries. This was so successful that the decision was made to adopt a common currency – the Euro.
4.     Britain, although a member of the European Union, declined to accept the Euro as its currency. However, many other nations within the EU have maintained their own currencies, such as Switzerland, the Czech Republic and Denmark.
5.     Recently, in the UK, there was a heated discussion on whether or not to remain in the EU. Many citizens thought that it would be better for the nation to leave the union, as they felt that its regulations put an excessive burden on them without providing any tangible advantage. They argued that progress and prosperity could be achieved more effectively outside of the EU.
6.     Britain’s move to depart from the European Union was coined ‘Brexit’..
7.     On 23rd June 2016, the UK held a referendum in which citizens voted on whether to remain in or leave the EU.
8. The result of the referendum was a huge surprise, with the UK making the decision to leave the EU. Most people in Britain and across the globe had expected them to remain part of it.

The referendum’s outcome sent a chill around traders and investors worldwide. The GBP plummeted to an all-time low, while the major European indices dropped by nearly 8-10%.

What is the cause of this? How have the Brexit and the currency markets been affected by this, and how has it impacted the jobs market?

I am expecting the past section to be useful in this situation.

In the prior chapter, we touched upon how an economic boom (influenced by different factors such as inflation, interest rates and trade deficit) translates to a robust currency.

When it comes to the UK, it’s obvious that the country has a strong economy and makes a major impact on the EU. However, with the UK leaving the EU, it can be expected that there will be drastic economic and political changes.

The UK’s economy and the EU are intertwined, as evidenced by its trade surplus within the bloc. Should there be a Brexit, this could potentially have a negative impact on its financials.

It is clear that the economy will be impacted, however no one can anticipate how. How will the Bank of England respond? Will they reduce interest rates to an all-time low? These are questions that remain unanswered.

The market has a distaste for uncertainty and Brexit has no shortage of it. Hence, the markets have reacted accordingly.

Being a currency trader, it is essential to examine the situation and familiarize yourself with some fundamentals. Drawing from my experience, I have noticed that profitable transactions can often be arranged merely by using sensible judgement and rudimentary understanding.

If you had done your research and in the end chose not to pursue a trade, then you made a wise move. The old saying goes “when in doubt, don’t”.

When events of this size are on the horizon it is absolutely essential that you’re aware of what’s going on. To take part in a trade without any previous knowledge would be nothing more than a blind gamble!

This concludes our discussion on Brexit and its potential to affect currencies.

Let us continue on to identify a few other currency ideas.

 – Fairy Trade

Envision a dreamlike realm: you can loan money at one rate and then invest the same funds to generate a greater return. To clarify, let me provide an example.

The United States interest rate is a mere 0.5%, making it one of the lowest globally. If $10,000 was taken out as a loan from an American bank at this rate, then investing in a nation like India with its 6-7% interest on similar borrowings would be awfully attractive.

In order to complete this transaction, the borrowed money (expressed in USD) should be converted to INR at today’s exchange rate, meaning that one US dollar equals 67 rupees. Thus, with $10,000 you will have the equivalent of 670,000 rupees. After that, we invest the money in India and anticipate a return of 7%.

At the end of the invested year, we get back 7% interest plus the initial capital. This would be –

670000 + 670000*(7%)

= 670000 + 46900

= Rs.716,900/-

We convert this money to USD, using the conversion rate of 67, giving us a total of $10,700. We have to pay back the principal sum plus 0.5% in interest; this comes to $10000 plus an additional $50.

So after repaying $10,050, we get to retain $650, which if you realize is a risk-free gain!

If you realize, $650 is the interest rate differential times the borrowed money –

10000*(7%-0.5%)

10000*(6.5%)

650

This is a simple case of arbitrage, quite easy to implement, don’t you think so?

Having this in mind, consider the possibility of obtaining a substantial loan from the US and investing it in India with the potential to generate considerable profits on a yearly basis.

Realistically speaking, there is no such thing as easy, risk-free profits like the ones in fairy tales. If they were to exist, they would be gone before you had a chance to take advantage of them.

We must ask ourselves: why is it not feasible to have a fair trade system?

 – Forward Premia & Interest Rate parity

The issue with the above deal is that there are too many suppositions; we presumed–

1.     We could borrow unlimited amounts of money in the US
2.     We could deposit unlimited amounts of money in India
3.     There is no cost of the transaction, no taxes
4.     Easy movement of currency between countries
5. Most importantly we assumed the conversion rate stayed flat at 67 after 1 year

The currency exchange rate one year later should prevent arbitrage from occurring, rendering it unsustainable over the long term.

The funds we acquire from India one year hence will be allocated towards repaying the banks in the US the following year.

As we discussed earlier, borrowing $10,000 from the US and investing it in India led to us receiving Rs.716,900/- after one year.

For arbitrage to not be a viable option, Rs.716,900/- must ultimately be equivalent to $10,050 after one year.

This means the conversion rate should be –

716900/10050

= 71.33

This is called the ‘Forward Premia’ in the currency world. The approximate formula to calculate the Forward Premia is –

F = S * ( 1+ Roc * N) / (1 + Rbc * N)

Where,

F = Future Rate

S = Today’s spot rate

N = Period in years

Roc = Interest rate in quotation currency

Rbc = Interest rate in base currency

Let’s use this formula to make sure the forward rate we get for this scenario is accurate, since the spot rate is 67.

F = 67*(1+7%*1) / (1+0.5%*1)

= 71.33

The forward premia rate is near identical to the spot rate plus the product of the spot and difference in interest rate.

F = S*(1+difference in interest rates)

= 67*(1+ 7% – 0.5%)

= 67*(1+6.5%)

= 71.35

This is called the ‘Interest rate parity’.

This Rupee is presently at a discount, trading at 67 compared to 71.35 in the future. It is commonly understood that any currency with a higher interest rate will be valued lower than one with a lesser rate.

We are discussing this because the forward premia is an important factor that affects futures pricing. Therefore, it has an impact on currency trading.

This will be something we will address further in the future.