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Exploring Covered Interest Rate Arbitrage

  • 13 Pages
  • Published On: 27-11-2023

Solution 1)

Covered Interest Rate Arbitrage is one of the more common types of arbitrage. It’s called covered arbitrage because the investor hedges the exchange rate risk ntries. To evaluate whether or not the covered interest arbitrage is worthwhile in the extant case we execute the following transaction. £ 9 Million is to be paid in 6 months time. Let’s assume that Tim & Co already has the exact amount which they need to pay after 6 months. Now this amount can be invested at the current prevalent domestic interest rate of 3.55% i.e. one year pounds’ sterling interest rate. Or else, Tim & Co can do an alternate transaction wherein they will convert the£ 9 Million available with them into Euro at the current spot rate. Given the current spot rate of € 1.4876 / £, post conversion of £ 9 Million, the Company has following in their hand = £ 9 Million * € 1.4876 / £ = €13388400 Whatsapp This amount can now be invested in the current one year Euro interest rate for six months at 4.10%. Subsequently, to cover the exposure, the amount has to be sold in the forward market in 6 months time. Assuming the rate to be same as given € 1.4906 / £ In other words, post 6 months, Tim & Co’s investment would be Interest Earned = €13388400 * 4.10% * 6/12 =€ 274462.2 Total amount in hand post6 months = € 13662862.20 The same when converted back to domestic currency, we have € 13662862.20 * 1 / € 1.4906 / £ = £ 9166015 Hence, over 6 months, yield earned = (£ 9166015 - £ 9 Million) / £ 9 Million = 1.84% in half year. So annualized return = (1+ 1.84%) ^2 – 1 = 3.71% This 3.71% return earned using covered interest rate arbitrage is higher than what Tim & Co would have earned had they remain invested in local currency i.e. 3.55%. Hence, the covered interest rate arbitrage is worthwhile for Tim & Co in the extant case. However, the conclusion comes with the caveat that covered interest rate arbitrage is worthwhile only if the hedging cost is less than the incremental return earned from the transaction. Similarly there are other factors like transaction cost, geo political risks and tax regulations etc that needs to be considered while making the decision.

Solution 2)

The principal and the key legislation for regulating the financial services sector in UK are the Financial Services and Markets Act 2000. This legislation has been amended over the years to encompass the evolving market scenario. This legislation also has subordinate legislations. This legislation on financial markets is based on 3 main pillars i.e. Financial Conduct Authority (FCA) Prudential Regulation Authority (PRA) and Bank of England’s Financial Policy Committee (FPC). The extent of the powers for each of the 3 pillars is well laid out in the Financial Services and Markets Act 2000. Now the Financial Policy Committee has some control over the other 2 arms of the act. The key responsibility of Financial Policy Committee is to mitigate the systematic risk. It acts as a macro prudential authority and monitors the financial system as a whole. Any breach in the system which may challenge the resilience and stability of the financial system is flagged by the FPC. In turn, FPC can channelize the Financial Conduct Authority as well as the Prudential Regulation Authority to ensure that the risk is mitigated at the earliest (Polk, 2019).

Now the Financial Conduct Authority looks after the retail and wholesale financial markets. It also monitors the infrastructure that supports the market in terms of its trading activities. Further, regulation of those which falls outside the realms of FSMA like e-money payment services and issuers are also governed by the Financial Conduct Authority. Not only this, the regulator for payment systems i.e. Payment Systems regulator (which is an independent arm of Financial Conduct Authority) is also governed by the Financial Conduct Authority. Thereafter the third pillar i.e. Prudential Regulation Authority ensures the financial wellbeing and appropriate risk management of the systematically important entities. Multiple entities like insurance companies, big investment companies and Banks falls under the purview of this management. The PRA authorizes as well as supervises these financial players (Holt, 2020). Most importantly, the common regularity interest of the financial services sector is required to be the common theme for all the regulators and their arms. The decision, regulation and monitoring is done in sync with each other to ensure that the broad guidelines set by the Financial Services and Market Act are adhered to in letter as well as in spirit.

The other regulations include the following –

  • Regulation EU 596/2014 on market abuse
  • Directive EU 2015/2366 in relation to payment services
  • Directive 2014/65/EU in relation to financial instrument and similarly there are many other regulations that comes into play when its about regulating the financial services sector.
  • It would however be prudent to mention that going forward a shift in the structure is expected with Brexit coming into force. However, while the name of the regulations may change, the theme and intention of the provisions will remain the same i.e. to safeguard the interest of all the stakeholders in the financial system.

Solution 3)

Taxes are part of our daily life and regardless of what strata of economy does an individual or corporate belongs to, tax avoidance in its entirety is impossible. Tax is a form of compulsory levy for all the stakeholders in the economy i.e. public authorities, private authorities as well as individuals. Taxes may also be viewed as transfer of money to the government for the good of the entire economy. The entire principal of taxation is divided into direct form of tax and Indirect form of tax. The bifurcation is generally dependent on assessment as well as collection basis. On a broad basis, the taxes can be bifurcated as Direct Tax and Indirect Tax.

Direct Tax

As the name suggest, the direct tax are the taxes which are paid directly to the government by an individual or an organization. The amount of tax is in proportion to income earned by the tax payer. Some of the major types of direct taxes are

Income Tax – One of the more prominent types of tax system which is prevalent at major locations in the world is income tax. Based on the overall income earned by the tax payer, certain percentage is pre-decided (generally in the form of slab).

Entitlement Tax – The taxation paid in order to avail certain entitlements is called as entitlement tax. Government charges these taxes to sustain social programs like social security, medical care facilities etc. These could be deducted directly from the pay slips of the salaried employee or paid separately by self employed, professionals and business people.

Property Taxes & Transfer Tax – In case of transactions (non monetary), wherein the ownership of property is passed from one person to another person then transfer tax comes into play. In some countries, property tax is a regular tax to be paid on the overall value of the property.

Capital Gain Taxes – Capital gain taxes are the taxes imposed on the sale of certain types of assets. The category of assets is like stocks, real estate, art work etc. The tax is generally paid on the gain earned i.e. the differential amount of the purchase price and sale price (Direct and indirect taxes, 2019).

Indirect Taxes

Indirect tax is not dependent on the income earned of the tax payer. These taxes are imposed on all at the same rate. The tax is generally charged on a supplier or manufacturer who in turns passes on the amount in full or in part to the end user. Some of the examples of such type of indirect taxes are as follows

  1. Sales Tax – The tax paid on the sale value of the asset i.e. the final selling price becomes inclusive of the tax, it’s called as sales tax. This is one of the more prevalent forms of taxation.
  2. Excise Tax – This is also one of the more common types of taxation wherein this special tax is imposed on certain selected items like Cigarette. Here, the manufacturer has the option to either absorb the tax on its own or to pass the amount to the end users.
  3. Custom Tax – This tax is imposed only on the items that are imported. Apart from being an additional source of revenue for the government, the custom tax also acts as a deterrent to imports. Governments use this tax to encourage domestic manufacturers.
  4. Fuel Taxes – Also known as the gas tax, this is the additional amount imposed on the price of the gas/oil/gasoline purchased. The tax is considered as an ecotax i.e. tax taken to reduce the dependence on such fuel for the safeguarding of the environment.
  5. Both types of taxes have a directly implication on different stakeholders. It would be wrong to say that taxes only increase the price of goods. Taxes are an essential source of income for the government which in turn takes social initiatives to support the economy and infrastructure. Some taxes (like Custom Tax) help in encouraging the domestic business and to prevent dumping of cheap goods from the international market. It is also used to influence the end users choice for example imposition of excise duty on alcohol and cigarettes increase the price of these products which is a way of telling the masses to reduce their usage (Indirect Taxes - Definition, Types and Examples, Advantages, n.d.).

Solution 4)

aracteristics – Liquidity – The security must be convertible into cash. While the ease of conversion cannot be commented upon as these depend on the prevalent market conditions but in general, the security needs to have the inherent ability to be convertible into cash. Marketability – The securities ought to be marketable in the sense that it can be bought, sold or exchanged over in a standardized manner. Tradability – One of the most important characteristic is that the security should be tradable over the market. In other words, these should be negotiable. Now there are different types of securities but these can be divided into 3 types on a broad basis Equity Securities Debt Securities and Derivative Securities. The sub classification along with inherent advantages and disadvantages are discussed below

Equity Securities

Equity generally refers to owing a stake in the Company. It’s the stock of the Company and lets the investor have an ownership of the Company whose equity stock is being held. Having an equity share means having made a contribution towards the capital of the Company (Borad, 2018). While all equity securities give ownership, the presence of so many different variety of it makes the income part unique for each type of ownership. Following are the key types of equity securities Common Stock – As the name suggests, these the most common type of equity stock which gives direct ownership of the entity. It is the most basic form of equity and is the first to be issued upon formation of the Company. Preferred Stock – Preferred stock is like common stock in the sense that it contributes to the capital f the Company. However, as the name suggests, this type of ownership has preferred claim over the cash flows of the entity. In lieu of the preferred access to the profits, preferred stocks normally do not have voting rights like common stock and has lesser responsibilities too. Even the preferred stock has multiple classifications like Convertible Preferred Stock, Cumulative Preferred stock etc. Retained Earnings – These retained earnings are part of the net worth of the Company and reflects the accumulation of the profit over the number of years. Dividend payments are subtracted from the profit earned and the accumulation of this balance is called as retained earnings. Treasury Stock – Some of the business houses may decide to buy back the stock from the open market or via private placements. This is where the concept of treasury stocks comes in. The treasury stock accounts for the amount paid to buy back shares. This type of stock is generally reported on a negative balance basis Other Comprehensive Income – OCI has recently come into play and reflects as part of the equity. However, Other Comprehensive Income is generally deducted from the bottom line of the PL statement because it reflects income that is yet to be earned. Advantages & Disadvantages of Equity Stock – One of the key advantages if equity stock is that like owners, the equity shareholders have right to the Company’s profit figures. The equity owners are allowed to participate in the operational decisions of the Company along with having the voting rights. Generally the return on the equity stock is considerably higher than other modes of investment. However, this also means that there is no fixed income from the stock. The possibility to earn partnership in the Company is raises the possibility to participate in the losses as well. Further, the income, in the form of dividend is available only after payment to other stakeholders like preferred stocks; debt etc has been paid off.

Debt Securities

In sync with its name, the key feature of this type of security is that it’s a form of loan to the Company. The owners of this security can be classified as lenders rather than owners of the Company. The amount involved, both in terms of the principal as well as the income (interest/coupon part) are normally fixed either as fixed amount or fixed percentage (Borad, 2018). The maturity date is also defined in advance. Following are the major sub categories of debt securities – Bonds and notes – These are debt securities via which a company borrow money from the market instead of a bank or financial organization. The price of the bond is inversely proportional to the prevailing interest rates. Also, empirically, bonds have a negative correlation with the equity market and hence are considered a good bet when it comes to diversification of portfolio. There are different types of bonds like Government bond, corporate bond, quasi government bonds, municipal bonds etc. Commercial Papers – Commercial papers are short term debt securities and generally availed by highly rated borrowers. The interest rate on commercial papers is generally very attractive to the company borrowing it. From investors’ perspective, since the commercial papers are generally much secured and for short term, lower rate of interest is compensated with lower risk on the investment. Interest Bearing Debt Securities – The interest bearing securities carry a fixed rate, floating rate or even a variable rate linked to some other benchmark. Depending on the risk appetite and depending on the investor’s view on the interest rate scenario, the investor can invest in any of the above types of interest bearing securities. Zero Coupon Debt Securities – These are non interest bearing securities. The zero coupon bonds are the bonds which are issued at a discount to the face value. At the time of redemption of the security i.e. at the time of maturity, the issuer of the zero coupon bond pays the full face value. Hence, the difference between the discounted issue value and final redeemed value is the return to the investor. Asset Backed Debt Securities – The Asset Backed Securities are debt securities which are issued by financial institutions. This type of security has an underlying asset which is income bearing assets. These are limited recourse structured securities. Advantages and Disadvantages – Like equity, the debt holders have rights as well. The key advantage to debt security is that these are income (fixed or variable) bearing instruments. The priority of payment for debt holders is above that of the equity holders. In the event of liquidation, the debt holders are considered more secured than the equity holders. However, the disadvantage is that the return is limited. As against high return earned by the equity holders, the debt holder’s return is generally lesser. There is no additional remuneration in case the Borrowing Company performs well (n.d.). Order Now

Derivatives

The derivatives are also financial instrument or securities which derive its value from the underlying asset. In other words, while the derivative is not a standalone asset in itself, it is built on the base of another asset. The underlying asset could be an index, a security, interest rate or any other financial instrument (Borad, 2018). Following are some of the common types of derivatives- Futures & Forwards – These are the derivatives which help the investor to secure a price to buy or sell the underlying currency, interest, stock etc at the future date. This type of derivative is an obligation as once entered, the investor has to honor the contract. The difference between forward and future is primarily that futures are standardized and available on exchange while forward is customized instrument. Options – As the name suggests, options are not obligator in nature and gives the option buyer the right to execute the transaction but not the obligation. The subtypes include Call option, put option and other derivatives of calls and puts. Swaps – Swaps allows the investor to change the obligation it has. For example, a Company receiving fixed rate of interest might enter into a swap so as it ensure that it actually receives floating interest rate. Advantages and Disadvantages - The advantage of derivatives is that it allows hedging of risky exposures. It is also knows to improve the market efficiency as any market difference is quickly removed. Further, sometimes an asset or a market is not accessible to the investor directly. In such a scenario, derivatives help in ensuring access to such market/ assets. However, the disadvantage is that derivatives are highly risky instrument. They are complex too and hence should be used only after understanding the basics of it. There is counterparty risk too in derivatives like forward contracts.

References

  • Borad, S., 2018. Financial Securities | Definition, Features, Types - Equity, Debt, Derivatives. [online] eFinanceManagement. Available at: [Accessed 9 February 2021].
  • Corporate Finance Institute. n.d. Indirect Taxes - Definition, Types and Examples, Advantages. [online] Available at: [Accessed 9 February 2021].
  • Holt, A., 2020. International legal business solutions - Global Legal Insights. [online] GLI - Global Legal InsightsInternational legal business solutions. Available at: [Accessed 9 February 2021].
  • IONOS Startupguide. 2019. Direct and indirect taxes. [online] Available at: [Accessed 9 February 2021].
  • Lexisnexis.com. n.d. [online] Available at: [Accessed 9 February 2021].
  • Polk, D., 2019. Financial Services Compliance in the United Kingdom | Lexology. [online] Lexology.com. Available at: [Accessed 9 February 2021].

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