Forex swap contracts are an integral part of the foreign exchange market. They are designed to help traders manage their currency risk by exchanging their currency holdings for another currency at a fixed exchange rate. However, for those who have a good understanding of the market conditions and the exchange rates, forex swap contracts can be used to earn arbitrage profits. In this article, we will explain how to solve a forex swap contract to earn arbitrage profit.
What is a Forex Swap Contract?
A forex swap contract is an agreement between two parties where they agree to exchange currencies at a predetermined exchange rate, with the settlement date being in the future. The settlement date can be a few days, months, or even years in the future. The exchange rate is fixed at the time of the contract, which allows both parties to protect themselves from any future exchange rate fluctuations.
Forex swap contracts can be used for a variety of reasons, such as hedging currency risk or financing foreign investments. However, they can also be used for arbitrage trading, which involves taking advantage of pricing discrepancies in the market to earn a profit.
How to Solve a Forex Swap Contract to Earn Arbitrage Profit?
To solve a forex swap contract to earn arbitrage profit, you need to identify a pricing discrepancy in the market. This can be done by comparing the exchange rates of two different currency pairs. For example, let’s say you notice that the exchange rate between the US dollar (USD) and the Japanese yen (JPY) is different from the exchange rate between the Euro (EUR) and the Japanese yen (JPY).
Assuming the exchange rate between the USD and JPY is 110, and the exchange rate between the EUR and JPY is 130, you can use a forex swap contract to earn arbitrage profit. Here’s how:
Step 1: Borrow USD
The first step is to borrow USD at a low-interest rate. This can be done by using a margin account with a forex broker. Alternatively, you can borrow USD from a bank or another financial institution.
Step 2: Convert USD to JPY
The next step is to convert USD to JPY at the current exchange rate of 110. This can be done by using a forex broker or a bank.
Step 3: Invest JPY
Now that you have JPY, you can invest it in a high-yielding Japanese bond or deposit account. This will earn you interest on your investment.
Step 4: Convert JPY to EUR
Once the investment has matured, you can convert JPY back to EUR at the current exchange rate of 130. This can be done by using a forex broker or a bank.
Step 5: Repay USD Loan
The final step is to repay the USD loan you took out in step 1. You will need to pay back the principal amount plus any interest that has accrued.
Calculating the Profit
To calculate the profit earned from this forex swap contract, you need to subtract the cost of borrowing USD from the interest earned on the JPY investment. For example, let’s say you borrowed USD 100,000 at an interest rate of 1% per annum and invested JPY 10,000,000 in a Japanese bond that yielded 2% per annum. After one year, you would earn JPY 200,000 in interest, which is equivalent to USD 1,818 at the current exchange rate of 110.
Therefore, your arbitrage profit would be USD 1,818 – USD 1,000 (cost of borrowing USD) = USD 818.
Conclusion
Forex swap contracts can be used to earn arbitrage profit by taking advantage of pricing discrepancies in the market. However, it is important to note that this strategy requires a good understanding of the market conditions and the exchange rates. Additionally, it is important to consider the risks involved, such as interest rate fluctuations and currency exchange rate movements. As with any investment strategy, it is important to conduct thorough research and seek professional advice before investing.
