Chapter 07a
Chapter 07a
Chapter 07a
7
International Arbitrage And Interest Rate Parity
Chapter Objectives
To explain the conditions that will result in various forms of international arbitrage, along with the realignments that will occur in response; and
To explain the concept of interest rate parity, and how it prevents arbitrage opportunities.
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International Arbitrage
Arbitrage can be loosely defined as
capitalizing on a discrepancy in quoted prices to make a riskless profit.
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International Arbitrage
As applied to foreign exchange and
international money markets, arbitrage takes three common forms:
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Locational Arbitrage
Locational arbitrage is possible when a
banks buying price (bid price) is higher than another banks selling price (ask price) for the same currency. Example Bank C Bid Ask NZ$ $.635 $.640
Bank D Bid Ask NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.
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Triangular Arbitrage
Triangular arbitrage is possible when a
cross exchange rate quote differs from the rate calculated from spot rate quotes.
Example
British pound () Malaysian ringgit (MYR) British pound ()
Bid
$1.60 $.200 MYR8.10
Ask
$1.61 $.202 MYR8.20
MYR8.10/ $.200/MYR = $1.62/ Buy @ $1.61, convert @ MYR8.10/, then sell MYR @ $.200. Profit = $.01/.
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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%.
Note: Profits are not achieved instantaneously.
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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.
Derivation of IRP
End-value of a $1 investment in the home
country = 1 + iH
Suppose 6-month ipeso = 6%, i$ = 5%. From the U.S. investors perspective,
forward premium = 1.05/1.06 1 - .0094
If S = $.10/peso, then
6-month forward rate = S (1 + p) _ .10 (1 .0094) $.09906/peso
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-1
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Interpretation of IRP
When IRP exists, it does not mean that
both local and foreign investors will earn the same returns.
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iH iF
Zone of potential covered interest arbitrage by foreign investors Zone where covered interest arbitrage is not feasible due to transaction costs
IRP line
Zone of potential covered interest arbitrage by local investors
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8% 8% 6% 6%
4% 2% 0%
Q3
Q3
Q1 2002
Q1
Q3
Q3
Q1
Q1 Q3 2003
Q1
Q3
i$ i
i$ = i i$ < i
-2%
Forward premium of
Q3
Q1 2002
Q3
Q1 2003
Q3
discount
-2% Q3 Q1 Q3 Q1 Q3 Q1 Q3
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2000
2001
2002
2003