206 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
Figure 5.11:Capital Adequacy Rules v 1.0 (Basel 1)The Bank for International Settlements of
Basel, Switzerland, has no power to impose
rules on banks anywhere. However, the BIS
deserves credit for bringing together the
regulatory bodies from most OECD
countries in a committee called the BIS
Committee, or the Basel Committee, or the
Cooke Committee (after the committee's
chairman), to create a common set of rules.
The objective of establishing a common set
of rules was to level the field for fair
competition.
Under the original agreement the
general capital requirement was 8 percent,
meaning that the bank's long-term funding
had to be at least 8 percent of its assets.For some assets and for off-balance-sheet
positions with a right of offset, the risk was
deemed to be less than the risk of a
standard loan to a company, and the
capital ratio was lowered correspondingly.
For instance, a loan to any (!?) government
or bank was assumed to have zero credit
risk, and did not require any long-term
capital. The rule was crude but was
deemed to be better than no rule at all.
This is now called Basel 1. The more
recent Basel-2 rules have replaced the 8%
rule for credit risks by a system of
ratings—external whenever possible, inter-
nal otherwise—and have added Value at
Risk (Chapter 13) to cover market risks.A more shady application of disguising one’s lending and borrowing arose when
a finance minister decided to speculate with the taxpayers’ money, and used swaps
for the purpose:
Example 5.32
At oneECCouncil meeting in the mid-1980s, even Margaret Thatcher, caught off
guard, was provoked into saying that she could not 100% exclude that theukmight
never ever think of discussing the option of joining a common European currency.
Belgium’s then finance minister, Mr Maystadt, concluded that the advent of the
common currency was a matter of a few years and that it would be introduced at
the official parities, without any interim realignments. From these views—which,
it later turned out, were both wrong—it followed that the huge interest differential
between Lira and Marks had become virtually an arbitrage opportunity. Thus,
speculation was justified: one should borrow in a low-interest currency, likedem,
and invest the proceeds in a high-interest one, likeitl(the “carry trade”). Still, the
country’s rule-books stated that the Finance Ministry could borrow only to finance
the state’s budget deficit. The minister therefore signed a huge long-term swap
contract instead, arguing that since the law did not mention swaps, their use was
unrestricted.
The whole deal blew up in his face when theermcollapsed in 1992 and theitl
lost one third of its value.
This has brought us to the end of our list of possible uses of forward contracts.
We close the chapter with a related management application, where we are not
strictly using the forward contract but rather the forward rate as a useful piece of