Chapter
7
INTERNATIONAL ARBITRAGE AND
INTEREST RATE PARITY
INTERNATIONAL ARBITRAGE
Arbitrage can be loosely defined as capitalizing
on a discrepancy in quoted prices. Often, the
funds invested are not tied up and no risk is
involved.
In response to the imbalance in demand and
supply resulting from arbitrage activity, prices
will realign very quickly, such that no further
risk-free profits can be made.
Location arbitrage is possible when a bank’s
buying price (bid price) is higher than another
bank’s selling price (ask price) for the same
currency.
INTERNATIONAL ARBITRAGE
Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D
@ $.645. Profit = $.005/NZ$.
Triangular arbitrage is possible when a cross
exchange rate quote differs from the rate
calculated from spot rates.
INTERNATIONAL ARBITRAGE
Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
£ MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR
@ $.200. Profit = $.01/£. (8.1.2=1.62)
INTERNATIONAL ARBITRAGE
$
Value of Value of
£ in $ MYR in $
£ MYR
Value of
£ in MYR
When the exchange rates of the currencies are not
in equilibrium, triangular arbitrage will force
them back into equilibrium.
INTERNATIONAL ARBITRAGE
Covered interest arbitrage is the process of
capitalizing on the interest rate differential
between two countries, while covering for
exchange rate risk.
Covered interest arbitrage tends to force a
relationship between forward rate premiums and
interest rate differentials.
INTERNATIONAL ARBITRAGE
Example:
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are
earning interest at 2%. Convert $ to £ at $1.60/£
and engage in a 90-day forward contract to sell £
at $1.60/£. Lend £ at 4%.
INTERNATIONAL ARBITRAGE
Location arbitrage ensures that quoted exchange
rates are similar across banks in different
locations.
Triangular arbitrage ensures that cross exchange
rates are set properly.
Covered interest arbitrage ensures that forward
exchange rates are set properly.
Any discrepancy will trigger arbitrage, which will
then eliminate the discrepancy. Arbitrage thus
makes the foreign exchange market more orderly.
INTEREST RATE PARITY (IRP)
Market forces cause the forward rate to differ
from the spot rate by an amount that is sufficient
to offset the interest rate differential between the
two currencies.
Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).
DERIVATION OF IRP
When IRP exists, the rate of return achieved from
covered interest arbitrage should equal the rate of
return available in the home country.
End-value of a $1 investment in covered interest
arbitrage = (1/S)(1+iF)F
= (1/S)(1+iF)[S(1+p)]
= (1+iF)(1+p)
where p is the forward premium, S is the spot rate, F is
the forward rate, iF is the interest rate on foreign deposit.
DERIVATION OF IRP
End-value of a $1 investment in the home country
= 1 + iH
Equating the two and rearranging terms:
p = (1+iH) – 1
(1+iF)
i.e.
forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)
DETERMINING THE FORWARD PREMIUM
Example:
Suppose 6-month ipeso = 6%, i$ = 5%.
From the U.S. investor’s perspective,
forward premium = 1.05/1.06 – 1 -.0094
If S = $.10/peso, then
6-month forward rate = S (1 + p)
_
.10 (1 .0094)
$.09906/peso
DETERMINING THE FORWARD PREMIUM
Note that the IRP relationship can be rewritten as
follows:
F – S = S(1+p) – S = p = (1+iH) – 1 = (iH–iF)
S S (1+iF) (1+iF)
The approximated form, p iH–iF, provides a
reasonable estimate when the interest rate
differential is small.
GRAPHIC ANALYSIS OF INTEREST RATE
PARITY
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
IRP line
2
Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
-2
-4
GRAPHIC ANALYSIS OF INTEREST RATE
PARITY
Interest Rate Differential (%)
home interest rate – foreign interest rate
Zone of potential 4
covered interest
arbitrage by IRP line
foreign investors 2
Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
Zone of potential
- 2 covered interest
arbitrage by
local investors
-4
TEST FOR THE EXISTENCE OF IRP
To test whether IRP exists, collect the actual
interest rate differentials and forward premiums
for various currencies. Pair up data that occur at
the same point in time and that involve the same
currencies, and plot the points on a graph.
IRP holds when covered interest arbitrage is not
worthwhile.
INTERPRETATION OF IRP
When IRP exists, it does not mean that both local
and foreign investors will earn the same returns.
What it means is that investors cannot use
covered interest arbitrage to achieve higher
returns than those achievable in their respective
home countries.
DOES IRP HOLD?
Various empirical studies indicate that IRP
generally holds.
While there are deviations from IRP, they are
often not large enough to make covered interest
arbitrage worthwhile.
This is due to the characteristics of foreign
investments, including transaction costs, political
risk, and differential tax laws.
CONSIDERATIONS WHEN ASSESSING IRP
Transaction Costs
iH – iF
IRP line
Zone of potential
covered interest
arbitrage by
foreign investors Zone of
p potential
Zone where covered
covered interest interest
arbitrage is not arbitrage
feasible due to by local
transaction costs investors
CONSIDERATIONS WHEN ASSESSING IRP
Political Risk
A crisisin the foreign country could cause its
government to restrict any exchange of the local
currency for other currencies.
Investors may also perceive a higher default risk on
foreign investments.
Differential Tax Laws
Iftax laws vary, after-tax returns should be considered
instead of before-tax returns.
EXPLAINING CHANGES IN FORWARD
PREMIUMS
Interest Rates
iA
Because of IRP,
iU.S.
a forward rate
will normally
move in tandem
with the spot
t0 t1 t2 time
rate.
Forward Rates
Spot and
This correlation
SA
depends on
FA
interest rate
movements,
t0 t1 t2 time i.e. p iH–iF
EXPLAINING CHANGES IN FORWARD
PREMIUMS
During the 1997-98 Asian crisis, the forward rates
offered to U.S. firms on some Asian currencies
were substantially reduced for two reasons.
The spot rates of these currencies declined
substantially during the crisis.
Their interest rates had increased as their
governments attempted to discourage investors
from pulling out their funds.
Thank You