CHAPTER – 7
INTERNATIONAL ARBITRAGE &
INTEREST RATE PARITY
International Arbitrage
• Arbitrage can be defined as capitalizing on a
discrepancy in quoted prices.
• 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.
International Arbitrage
• Locational arbitrage is the process of buying a
currency at the location where it is priced
cheap and immediately selling it at another
location where it is priced higher.
• Locational arbitrage is possible when a bank’s
buying price (bid) is higher than another bank’s
selling price (ask) for the same currency.
International Arbitrage
• Locational arbitrage Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $0.635 $0.64 NZ$ $0.645 $0.65
[Link] NZ$ from Bank C @ $.640, and
[Link] it to Bank D @ $.645.
[Link] = $.005/NZ$.
International Arbitrage
• Triangular Arbitrage in which currency
transactions are conducted in the spot market to
capitalize on a discrepancy in the cross exchange
rate between two currencies.
• This is possible, if quoted cross exchange rate
differs from the appropriate cross exchange rate.
• Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $0.20 $0.202
£ MYR 8.1 MYR 8.2
International Arbitrage
• Steps:
1. Buy £ @ $1.61,
2. convert @ MYR 8.1/£,
3. then sell MYR @ $.200.
4. Profit = $.01/£. (8.1.2=1.62)
• 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:
Fund available: $800,000
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
•Steps:
[Link] $ to £ at $1.60/£ and invest £ at 4%.
[Link] in a 90-day forward contract
[Link] the forward contract on maturity and sell £ at
$1.60/£.
[Link] the yield earned on arbitrage.
International Arbitrage
• As many investors capitalize on covered interest
arbitrage, there is:
– Upward pressure on the spot rate and
– Downward pressure on the 90-day forward rate.
• Once the forward rate has a discount from the spot
rate that is about equal to the interest rate
advantage, covered interest arbitrage will no longer
be feasible.
International Arbitrage
Example:
• Fund available: $800,000
• Spot rate of £ = $1.62
• 90-day forward rate = $1.5888
• U.S. 90-day interest rate = 2%
• U.K. 90-day interest rate = 4%
Interest Rate Parity (IRP)
• Sometimes market forces cause the forward
rate to differ from the spot rate by an amount
that is sufficient to offset the interest rate
differential between the two currencies.
• Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).
Determining the Forward Premium
i.e.
• forward =
(1 + home interest rate) – 1
premium (1 + foreign interest rate)
Determining the Forward Premium
Example:
• Suppose 6-month ipeso = 6%, i$ = 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
• Such a discount would offset the interest rate
advantage of the peso.
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.