Saturday, May 24, 2008

FX Swaps Misbehaving

(Models & Agents) You’re in the middle of planning a summer tour of “classical” Greece for your family: The Parthenon in Athens, the spectacular oracle in Delphi, the ancient theater of Epidauros, a few beaches in between. But you need around 15,000 euros. What do you do? Well, a number of things:

Spots and forwards:
(a) You can go to your bank and get a one-year loan of 15,000 euros at, say, 4.00% interest. After one year you’ll have to pay back €15,600—principal and interest.

(b) You can go to your bank, borrow 23,250 dollars for a year at, say, 2.00% interest and then exchange them for euros at your local foreign exchange office. At around 1.55 dollars for each euro (the current “spot” rate), you get the €15,000 that you need. After one year, you will have to return $23,715 to your bank.

In both cases the “story” is the same: A curious American with good credit record and a liking for “history with some beaches in between,” borrowing 15,000 euros. Therefore, provided that there are no rules stopping you from borrowing in euros; and the transaction fees are the same; both options should cost exactly the same.

It's easy to see that (a) and (b) will cost the same if you and your bank agree today to change dollars for euros at a rate of $/€1.52 in a year's time: Under the first option, you pay back €15,600. In the second, you pay $23,715. The 1.52 is the ratio of the two amounts. This agreement with your bank is a one-year forward agreement; and the exchange rate that you pre-determine (here 1.52) is the forward rate.

Parthenon or Disneyland? Turns out, you have one more option: You go to your bank and borrow $23,250 at 2.00% interest. You then go online and place an ad: “Does anyone out there want to swap dollars for euros?”

Soon enough, a Greek appears: Very business-minded, he wants to lend the dollars to his neighbor, who is planning a summer vacation with his family to the American equivalent of the Parthenon: Disneyland!

So the two of you enter an agreement—a foreign exchange swap agreement: The Greek gives you 15,000 euros for a year, in exchange for your $23,250—fair, since the spot exchange rate is 1.55. At the end of the year he will give you $23,250 back in exchange for euros. But how many euros should you pay him back? Put it differently, at what exchange rate will you swap the dollars back to euros?

Once again the “story” is fundamentally the same—you borrowing 15,000 euros. So if the costs of the transaction are the same and IF, of course, you can trust the Greeks, you should be indifferent about which option to choose. This means you should be paying the same rate as in (b)—the forward rate of 1.52—which translates to around 15,300 euros for the Greek.

Swaps misbehaving: However convoluted this swapping sounds, this is exactly what many banks do when they want to raise funds in foreign currency: They borrow in their local currency and then swap it in the FX swap market. And when it comes to the dollar and the euro, the most widespread currencies in the world, this market extremely deep and liquid…

...Till last August! Suddenly, FX swaps seemed far more expensive than "option (a)"--that is, borrowing dollars directly from other banks at the so-called LIBOR rate (the interest rates at which banks lend to each other). But why did that happen? Why didn’t Europeans switch to the (apparently) cheaper Libor market? Haven't they heard of arbitrage? Are they not that smart?!

A number of explanations have been on offer.

Can't trust the Greeks? One possibility is "discriminatory" mistrust against Europeans—say if they were suddenly perceived as exceptionally risky. This could have raised the price of FX swaps, on which Europeans relied most, above the Libor, which applies to a wider pool of banks. Possible, though not entirely compelling: Thinking of the names that were floating around as potential “time-bombs” (Lehman, Citigroup or the now legendary Bear Stearns), I’d say American banks were at least as deep in trouble.

Premium for collateral? Another has to do with a subtle difference between the Libor and FX swap markets. Remember your swap with the Greek? Suppose he disappeared and never paid you back. Bad, though not terrible! You simply don’t pay him back either. That is, in a FX swap agreement you can use your obligation to repay as “collateral,” or insurance against the risk that your counterparty fails you. This is not the case when you borrow outright from your bank, without collateral. So in an environment of mutual mistrust, Europeans might have had trouble borrowing in the (uncollateralized) Libor market, turning therefore to the FX swap market to get dollars. And as they flood in, the market gets crowded and… more and more expensive.

Blame it on the Libor? Another explanation has to do with the Libor itself. The Libor is an average rate of interest that banks lend to each other, calculated based on quotes from a panel of 16 banks. These 16 banks are selected on the basis of their “reputation, scale of market activity and perceived expertise in the currency concerned.” It is therefore conceivable that, if the need for dollars were disproportionately larger for banks that are not in the panel (e.g. small, regional or less creditworthy banks which should typically pay rates above Libor), the FX swap market would have reflected the (more expensive) funding costs of these banks.

Cheating? As always, there is cheating. With everyone wary of which bank will be the next to fall, there were rumors that some of the banks in the Libor panel were quoting rates that were lower than their true borrowing costs. Why would they do that?? Because a high rate might raise suspicions they had trouble raising money, prompting a stampede against them.

Where does this leave us? While the explanations are not 100 percent conclusive, we know at least one thing: FX swaps have been darn expensive! And this can throw light to a couple of questions that have kept me from sleeping for a few weeks:

Why is the US Fed providing the European Central Bank (ECB) with dollars? And why on earth does the ECB have to be the dollar provider for European banks? Isn’t the foreign exchange market for the euro and the dollar the deepest and most liquid in the world? Yes, normally… but for now, FX swaps are misbehaving!

Are European banks more in trouble that their American brethren? Not necessarily. At the Fed’s recent auction to lend dollars to (primarily) American banks (the so-called Term Auction Facility), demand for dollars was record high, at around 97 billion. So the ability to raise money is similarly dire on both sides of the Atlantic.

Finally, can you trust the Greeks? Most of the times... And when you go to Delphi, don’t forget to ask the oracle when this will all end!

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