9/6/2021

International Corporate Finance 7 International Arbitrage And Interest Rate Parity

11th Edition Chapter Objectives

by Jeff Madura
• Explain the conditions that will result in various forms of
international arbitrage and the realignments that will occur in
1. response

• Explain the concept of interest rate parity

2.

• Explain the variation in forward rate premiums across maturities

and over time
3.

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International Arbitrage Locational Arbitrage

n Defined as capitalizing on a discrepancy in quoted prices by Where should you buy and sell GBP? What is your gain?
Case 1:
making a riskless profit.

n Arbitrage will cause prices to realign.

n Three forms of arbitrage:

§ Locational arbitrage

§ Triangular arbitrage

§ Covered interest arbitrage Case 2:

AKRON BANK ZYN BANK

BID ASK BID ASK
British pound quote 1.63 1.64 1.60 1.61

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Exhibit 7.2: Locational Arbitrage Locational Arbitrage

PRACTICE: Given Beal Bank and Yardley bank:

Beal Bank Yardley bank

Bid (NZD) $.401 $.398
Ask (NZD) $.404 $.400

1. Is locational arbitrage possible? Suppose that an investor have 1,000,000 USD. How he can make money
from locational arbitrage?
2. Explain the steps involved
1. Is locational arbitrage possible?
3. What market forces would occur to eliminate any further 2. Explain the steps involved. Calculate the profit.
possibilities of locational arbitrage. 3. What market forces would occur to eliminate any further possibilities of
locational arbitrage.

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Locational Arbitrage Triangular Arbitrage

1. Defined as the process of buying a currency at the location where it is Given exchange rate quoted in the market as follows:
priced cheap and immediately selling it at another location where it is Bank A: 1 GBP = $1.6
priced higher. Bank B: 1 GBP = 8.1 MYR
2. Gains from locational arbitrage are based on the amount of money Bank C: 1 MYR= $ .20
used and the size of the discrepancy.

3. Realignment due to locational arbitrage drives prices to adjust in

Question: How to make money from arbitrage if you have 10,000 USD?
different locations so as to eliminate discrepancies.

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Exhibit 7.3 Example of Triangular Arbitrage Triangular Arbitrage (Bid/Ask)

On the given market, Bank A, B,C respectively quoted as follows:

Bid Ask

(A) Value of British pound in U.S dollars $1.60 $1.61

(B) Value of Malaysian ringgit (MYR) in US dollars $0.200 $0.201

(C) Value of British pound in Malaysian ringgit MYR8.1 MYR8.20

(MYR)

If you invest 10000 USD, what are your steps to make arbitrage?

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Exhibit 7.5 Example of Triangular Arbitrage Accounting Triangular Arbitrage

for Bid/Ask Spreads

1. Defined as currency transactions in the spot market to capitalize on

discrepancies in the cross exchange rates between two currencies. (See
Exhibits 7.3, 7.4, & 7.5)

2. Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread)

can reduce or even eliminate the gains from triangular arbitrage.

3. Realignment due to triangular arbitrage forces exchange rates back into

equilibrium. (See Exhibit 7.6)

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Application 1 Covered Interest Arbitrage

Given the market conditions as follows:

1. Defined as the process of capitalizing on the interest rate differential

Exchange rate Bid Ask between two countries while covering your exchange rate risk with a
forward contract.
(A) Euro/USD 1.1795 1.1799
2. Consists of two parts: (See Exhibit 7.7)
(B) Euro/AUD 1.6522 1.6530
a. Interest arbitrage: the process of capitalizing on the difference between interest

(C) AUD/USD 0.7301 0.7303 rates between two countries.

b. Covered: hedging the position against interest rate risk.

What is your profit in USD from implementing this strategy if you have 3. Realignment due to covered interest arbitrage causes market realignment.
$100,000 available.
4. Timing of realignment may require several transactions before realignment
is completed.

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Covered Interest Arbitrage Exhibit 7.7 Example of Covered Interest Arbitrage

You have $800,000 available in 90 days to invest. The market condition is

shown as follows:

- S(GPB/USD)=1.6

- F(GBP/USD) in 90 days: 1.6

- r (USD) in 90 days: 2%

- R (GPE) in 90 days: 4%.

What should you do if you desire to capitalize on your available funds?

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More Practice Review: Comparing Arbitrage Strategies

Spot rate $0.85

Three month forward for SF $0.80/SF

Three month interest rate for SF annualized 12%

Three month interest rate for USD annualized 18%

Which currency would you borrow and how much is the arbitrage profit?

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Exhibit 7.7: Example of Covered Interest Arbitrage (CIA) Exhibit 7.7 Example of Covered Interest Arbitrage

You have $800,000 available in 90 days to invest. The market condition is

shown as follows:
- S(GPB/USD)=1.6 (1GBP = $1.6)
- F(GBP/USD) in 90 days: 1.6 (1GBP = $1.6)
- i(US) in 90 days: 2%
- i(GB) in 90 days: 4%.
What should you do if you desire to capitalize on your available funds?

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Interest Rate Parity Interest Rate Parity

𝑨𝒉 The amount of home currency (US dollars) 1  ih

p  1
1 if
S The spot rate
where
𝒊𝒇 The interest rate on the foreign deposit
p  forward premium
𝒊𝒉 The interest rate on the domestic deposit i h  home interest rate
i f  foreign interest rate
The forward rate in dollars at which the foreign
F currency will be converted back to USD.
In equilibrium, the forward rate differs from the spot rate by a sufficient
p The forward premium amount to offset the interest rate differential between two currencies.

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Example 1 (Q21) Determining the Forward Premium

Assume that annual interest rates in the United States are 4%, while The relationship between the forward premium (or discount) and
the interest rate differential according to IRP is simplified in an
interest rates in France are 6%. approximated form:
a. According to IRP, what should the forward rate premium or
discount of the euro be? F S
p  ih  i f
S
b. If the euro’s spot rate is $1.10, what should the 1-year forward rate where
of the euro be? p  forward premium (or discount)
F  forward rate in dollars
S  spot rate in dollars
ih  home interest rate
i f  foreign interest rate

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Exhibit 7.11 Quoted Interest Rates for Various

Variation in Forward Premiums
Times to Maturity

Forward Premiums across Maturities

The forward premium must adjust to existing

interest rate conditions if interest rate parity
holds.

Changes in the Forward Rate

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Interpreting Exhibit 7.9

Exhibit 7.9 Illustration of Interest Rate Parity
Illustration of Interest Rate Parity

n Points representing a discount: points A and B

n Points representing a premium: points C and D
n Points representing IRP: points A, B, C, D
n Points below the IRP line: points X and Y
Investors can engage in covered interest arbitrage and earn a higher
return by investing in foreign currency after considering foreign interest
rate and forward premium or discount.
n Points above the IRP line: point Z
U.S. investors would achieve a lower return on a foreign investment
than on a domestic one.

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Exhibit 7.10 Potential for Covered Interest Arbitrage Interpreting Exhibit 7.9
When Considering Transaction Costs Illustration of Interest Rate Parity (Cont.)

n How to Test Whether Interest Rate Parity Exists

§ The location of the points provides an indication of whether
covered interest arbitrage is worthwhile.
§ For points to the right of the IRP line, investors in the home
country should consider using covered interest arbitrage, since a
return higher than the home interest rate (ih) is achievable.
§ Of course, as investors and firms take advantage of such
opportunities, the point will tend to move toward the IRP line.
§ Covered interest arbitrage should continue until the interest rate
parity relationship holds.

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Example 4: Covered Interest Arbitrage in Both

More on Interest Rate Parity
Directions

The 1-year interest rate in New Zealand is 6%. The 1-year U.S 1. Interpretation of Interest Rate Parity
interest rate is 10%. The spot rate of the New Zealand dollar Interest rate parity does not imply that investors from different countries
(NZ$) is $.50. The forward rate of the New Zealand dollar is will earn the same returns.
$.54. Is covered interest arbitrage feasible for U.S investors? Is 2. Does Interest Rate Parity Hold?
it feasible for New Zealand investors? In each case, explain why
Compare the forward rate (or discount) with interest rate quotations
covered interest arbitrage is or is not feasible.
occurring at the same time. Due to limitations in access to data, it is
ANSWER: difficult to obtain quotations that reflect the same point in time.
14.48%

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Considerations When Assessing Interest Rate Parity SUMMARY

n Locational arbitrage may occur if foreign exchange quotations differ

among banks. The act of locational arbitrage should force the foreign
exchange quotations of banks to become realigned, and locational
arbitrage will no longer be possible.
IRP 1. Transaction costs n Triangular arbitrage is related to cross exchange rates. A cross
exchange rate between two currencies is determined by the values of
these two currencies with respect to a third currency. If the actual cross
2. Political risks exchange rate of these two currencies differs from the rate that should
exist, triangular arbitrage is possible. The act of triangular arbitrage
3. Differential tax laws should force cross exchange rates to become realigned, at which time
triangular arbitrage will no longer be possible.

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SUMMARY (Cont.) SUMMARY (Cont.)

n Covered interest arbitrage is based on the relationship between the forward n Interest rate parity (IRP) is a theory that states that the size of the forward
rate premium and the interest rate differential. The size of the premium or premium (or discount) should be equal to the interest rate differential
discount exhibited by the forward rate of a currency should be about the between the two countries of concern. When IRP exists, covered interest
same as the differential between the interest rates of the two countries of arbitrage is not feasible because any interest rate advantage in the foreign
concern. In general terms, the forward rate of the foreign currency will country will be offset by the discount on the forward rate. Thus, the act of
contain a discount (premium) if its interest rate is higher (lower) than the covered interest arbitrage would generate a return that is no higher than
U.S. interest rate. what would be generated by a domestic investment.
n If the forward premium deviates substantially from the interest rate
differential, covered interest arbitrage is possible. In this type of arbitrage,
a foreign short term investment in a foreign currency is covered by a
forward sale of that foreign currency in the future. In this manner, the
investor is not exposed to fluctuation in the foreign currency’s value.

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SUMMARY (Cont.)

n Because the forward premium of a currency from a U.S. perspective is

influenced by the interest rate of that currency and the U.S. interest rate and
because those interest rates change over time, the forward premium
changes over time. Thus the forward premium may be large and positive in
one period when the interest rate of that currency is relatively low, but it
could become negative (reflecting a discount) if that interest rate rises
above the U.S. interest rate.

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