Macro trader insights: FX parity definition
Two traded currencies with equal value
Imagine you are the head of treasury of a large European financial institution and you have one billion Euros in deposit with the European Central Bank (ECB) and earning a negative rate of -0.50% on your deposit. The ECB is charging you 0.5% to hold those Euros and because of this your financial institution now has to suffer losses to the tune of 5 million euros every 12 months on those ECB deposits.
Then one day you show up to work at your treasury desk and you notice that the EUR is trading at equal value to the US Dollar (parity). Hmm. So you call your friend at a US bank and ask where the USD overnight bank funding rate is? He replies: ‘it's at 1.5%’. You say ‘thank you’ and hang up the phone.
Hmm….you think….so, if the EUR/USD is trading at equal value and I’m being charged 0.5% to hold euros, while my friend at the US bank is earning 1.5% on USD deposits, I know that I could exchange my euros for dollars and take the higher rate, however at what risk? And is a 1.5% yield on a USD deposit worth the risk for me to exchange my euros? What will happen if the euro gains against the USD by the time I need to convert my USD’s back into EUROs?
Now come back from the land of imagination. Wait….maybe you're not the head of treasury at a large European financial institution…but…. the rest of the above short story is the day-to-day reality of corporate treasury departments around the world.
Sure it's easy to exchange euros for dollars today because the rate looks good, however this transaction is not risk free and traders should have to consider the exchange rate risk.
Not investment advice. Past performance does not guarantee or predict future performance.