An Icelandic Krona Hedge Question

[FX Targets]

Iceland has recently put its base rate to 13.5% with no sign of any let up in inflation fueled by property and investment surges.

If I wanted to borrow £xyz at 8% in the UK and benefit from a estimated 13.5% at Icelands current rate, what would be the best way to construct this position?

I'd want to run the position for a max of 2 years but with the ability to close it out at any time.

Is there any way I can lock in the differential risk free? If so, could you explain precisely how I can do this? You'll need to spell it out as I am new to trading.

I'm guessing some form of futures or bond with a hedge into the currency side of things. The closest I've come to on a search is interest rate swaps, but these look mainstream and not something a relative amateur like myself would be getting into.

I'd really appreciate your help in understanding the mechanics a position such as this would require as it's my intention to trade it.

 

[FX Targets]

Is this a compex position to construct or is it just out of the normal for these boards?

 

[TWI]

Have you looked at the fx cross 2 years forward to see what you would be making if you borrowed GBP at 8% spot and bought Icelandic Krone spot and then locked in a swap 2 years forward?
Only way is to take a risk that sterling depreciates against this currency over the period so may as well borrow less money and take leveraged directional bet on the fx cross.

 

[A Dashing Blade]

Have you looked at the fx cross 2 years forward to see what you would be making if you borrowed GBP at 8% spot and bought Icelandic Krone spot and then locked in a swap 2 years forward?

Zero-sum game surely, as forward rates are determined by current spot and the two domestic interest rates.

Trivial "just to illustrate the point" example . . .

Say
GBP/USD is at exactly 2.00000
1 year GBP rate (ie deposit GBP for 1 year) = 6.00%
1 year USD rate (ie deposit USD for 1 year) = 5.30%
I've got GBP 1,000,000

So, I have the choice of
1) sticking my GBP on deposit, earning 6% to receive 1,060,000 in a year's time

or

2) converting to USD @ 2.0000 and sticking the USD 2,000,000 on deposit
to receive 2,106,000 in a year's time

The 1 year forward rate (ie a guarenteed exchange rate 1 year forward from the date 1 do the trade) becomes
2,106,000/1,060,000 = 1.986792

Anything else opens up an arbitrage opportunity.

Think I've got that right, happy to be corrected etc

 

[FX Targets]

Have you looked at the fx cross 2 years forward to see what you would be making if you borrowed GBP at 8% spot and bought Icelandic Krone spot and then locked in a swap 2 years forward?
Only way is to take a risk that sterling depreciates against this currency over the period so may as well borrow less money and take leveraged directional bet on the fx cross.

I don't understand. What is 'fx cross 2 years forward'? What do you mean by 'lock in a swap''?

 

[FX Targets]

Zero-sum game surely, as forward rates are determined by current spot and the two domestic interest rates.

Trivial "just to illustrate the point" example . . .

Say
GBP/USD is at exactly 2.00000
1 year GBP rate (ie deposit GBP for 1 year) = 6.00%
1 year USD rate (ie deposit USD for 1 year) = 5.30%
I've got GBP 1,000,000

So, I have the choice of
1) sticking my GBP on deposit, earning 6% to receive 1,060,000 in a year's time

or

2) converting to USD @ 2.0000 and sticking the USD 2,000,000 on deposit
to receive 2,106,000 in a year's time

The 1 year forward rate (ie a guarenteed exchange rate 1 year forward from the date 1 do the trade) becomes
2,106,000/1,060,000 = 1.986792

Anything else opens up an arbitrage opportunity.

Think I've got that right, happy to be corrected etc

Thank you for your response. But the scenario you've outlined shows a lesser interest rate on the 'other' currency (USD in your example). My position shows a much higher rate for the 'bought' currency.

Put simply, if I borrow here in the UK at 8% and invest in Iceland at 13.5% I pocket the 5.5% difference.

All I then need to do is hedge against the Iceland Krona weakening against the Pound. So how could I do that?

 

[A Dashing Blade]

. . .
All I then need to do is hedge against the Iceland Krona weakening against the Pound. So how could I do that?

The point is that the hedge is done thru the forward rate which will always take account of relative interest rates. ie in this Krona example, the GBP/ISK rate will be higher than it is now . . .
ie current USD/ISK spot is 63.65 in round numbers, current 1year forward rate is 68.78 on reuters (page ISKF=), this reflect 1 year depo rates of 13.80% & 5.30% (again, very round numbers as the bid/ask spread for spot & ratesis pretty high).

Actual numbers are spot = 63.67 - 63.69, 1 year forward fx quoted 512.6 - 529.1 ie add on 5.126 & 5.291 to the spot rate, Icelandic 1year depo is 13.65 - 13.90%, USD 1 year is 5.26 - 5.34%. All as of 16.15 BST today

 

[TWI]

I don't understand. What is 'fx cross 2 years forward'? What do you mean by 'lock in a swap''?

A Dashing Blade I think explained in far more detail. Investigate via google something called "the carry trade".

 

[A Dashing Blade]

Don't need Google to tell me what the carry trade is tvm.

I'm answering the "Is there any way I can lock in the differential risk free? " part of the OP. I do not belive carry trades to be risk-free.

Wrt to the specifics, there are a couple of issues . . .
1) You may be able to get an ISK/GBP spot quote but that's it. Nothing else available, everything is via other Skandie or USD.ie two sets of spreads are gonna have to be taken into account.
2) I would have thought GBP interest rate view would be bias up.
3) ISK rates (observed thru the swap curve) fall substantially at after the one year point.

 

[FX Targets]

'TWI' and 'A Dashing Blade', thank you both very much for your detailed responses. It's taken me a while to do the research to even begin to understand what you were telling me. And I thank you for that. It's frightening just how much I don't yet know. Are you guys both pro traders or is this a fairly average discussion on trading matters? I'm pleasantly blown away with how much fun this is going to be just to get to where I can talk reasonably intelligently about these issues.

Research still on going, but if I'm reading you both right, the cheapest and easiest way of netting the differential in interest rates between the two countries would be for me to (a) borrow GBP (b) directly invest that into a standard high-street savings account in Iceland and (c) keep an eye on exchange rates & spot currency rates which are linked anyhow and exit my position on a discretionary basis. It's hardly likely to move against me the entire size of the differential overnight.

Any attempt to hedge this position will lead to (a) increased cost (b) greater complexity and (c) little if any additional limit to risk.

 

[riwf]

FX Targets

I'm not sure that you'll find it easy to open a savings account with an Icelandic high street bank. There are Icelandic banks operating in GB and they only pay a British-level interest rate. I think if you tried to open an account with a bank based in Iceland they'd direct you to their British subsidiary.

If you went to Iceland in person, I still think you're run into trouble. You'd need to be resident, with an Icelandic address. So far as I know, Iceland isn't a member of the European Community, so you'd require a visa and a residency permit.

If it is possible to go to Iceland for a day or two and open up a savings account, I think you'd have to take a large thermos with you to sustain yourself while you wait in the very long queue of Japanese amateur traders who have borrowed vast amounts of Yen at 0% interest rate to take the same advantage of Iceland's high interest rates that you are seeking.

Best of luck, though.

RIWF

 

[FX Targets]

riwf, you have correctly assessed my trading colour as being the greenest of greens, quite true. I just wondered if there was a professional/viable/possible way to take advanatge of this situation.

As you suggest, it is my extremely amateur view on what is after all probably the most highly developed system (the financial markets) in any area of global commerce that leads me down what increasingly appears to be a cul-de-sac.

Any possibilities for easy arbitrage would quickly have been taken by the professionals and quite likely, have ironed out the differential in the process.

But it is the very continuing existence of that differential and the obvious lack of any restriction theoretically to take advantage of it that leaves me, still green I am sure, and still wondering what can be done.

Surely a trusted realtive domiciled in Iceland would do the trick in the most basic of plans?

It has also just occurred to me that if there is a really cute way of leveraging this or any other interest rate difference, I'm hardly likely to be handed the keys to the toy cupboard at Christmas, even here, in the Hamleys of the trading world.

The only key I have been given here, and possibly the most useful one I could have ever been given, is that of doing my research. ANd more research.

I look forward to the time when I can revisit these posts of mine and blush in spine-cracking spasms of cringe at my then desperate degree of absolute cluelessness.

 

[riwf]

Landsbanki is Iceland's largest commercial bank. It's ordinary savings account pays 4.55% - A Level 1 or Level 2 account pays 10.45% and 11.05% respectively, but if you withdraw money without giving 60 days' notice the interest is calculated at the ordinary rate. So even if you had an obliging Icelandic relative it's doubtful that you'd be able to operate the system to your advantage.

Best thing you could do would be to trade currency options with the Icelandic Krona as one of the pairs. Do your research and decide whether you think interest rates in Iceland are going to go up or down over the next three months, six months or a year and therefore weaken or strengthen the Krona against the partner you've picked. Then find a broker who offers Contracts for Differences - dozens of them around - and buy or sell the option. If the price moves in your favour you can sell early at a profit. If it moves against you sell and minimise your loss.

RIWF

 

[A Dashing Blade]

Hows about buying ISK denominated bonds? You should be able to pick them up through a stockbroker, as of this moring, AAA rated commercial paper avaiable is . . .


NIB 11.5 09/07 ISK 98.833/ 99.583 14.248/11.933
DB 11.25 09/07 ISK 98.757/ 99.007 14.241/13.470
EXPT 8.5 09/07 ISK 98.086/ 98.586 13.979/12.405
KFW 8.25 09/07 ISK 97.728/ 97.828 14.242/13.954
RENTEN 12.0 10/07 ISK 98.822/ 99.122 14.180/13.406
SEK 12.5 10/07 ISK 98.939/ 99.439 14.131/12.961
AAB 14.0 01/08 ISK 99.973/100.123 13.411/13.176
DB 12.5 01/08 ISK 99.282/ 99.582 13.121/12.658
RABOBK 13.5 01/08 ISK 99.582/ 99.832 13.598/13.226
KFW 11.0 02/08 ISK 98.574/ 99.474 13.078/11.774
RABOBK 11 04/08 ISK 98.796/ 98.996 12.353/12.103

Dammit, can't get the formatting right! (Bond, Coupon, Maturity, Bid/Ask Price and Bid/Ask Yield are the columns)

All are annual bonds so anything maturing in less than a year is (effectively) a zero coupon bond. ie the KFW 11% of Feb 08, pay 99.474 now, to receive redemption amount + final coupon of 100 + 11 = 111 at maturity.

 

[THE WOLF2222]

I have been perusing the T2W forum for a while now and hae enjoyed the weath of information it provides.

Anyway...

That looks like a very low risk way to make a very strong % gain.

What are the potential pitfalls (other than capital gains tax)? These all look too good to be true when compared to UK gilts and savings accounts.