Arbitraging

Risk free gain.

Exercise 1
Given the following data: Spot Rate: Rs 35.0020 = $1 6-m Forward Rate: Rs 35.9010 = $1 Interest rate on Rs = 12% pa Interest rate on $ = 7% pa Work out the arbitrage possibilities

Where to invest? First calculate:

1. Interest Rate Differential in absolute terms. 2. Annualized rate of Premium/Discount. 3. Compare IRD with ARP/D

Where to invest? Decision:

1. If IRD > ARP/D, invest in the country having Higher Interest Rate. 2. If IRD < ARP/D, invest in the country having Lower Interest Rate.
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Annualized Rate of Premium or Discount

Say, Spot Rate: $1=Rs 35.0020 6-m Forward Rate: $1=Rs 35.9010
Premium or Discount of Which Currency? $ or Rs???
$ Premium or Discount Rs Premium or Discount
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Annualized Rate of Premium or Discount

Say, Spot Rate: $1=Rs 35.0020 6-m Forward Rate: $1=Rs 35.9010

FR SR 12 ----------* ----* 100 SR 6

5.136

Note it Carefully
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Where to invest?
As IRD (5%) is < ARP (5.136) Invest in US! Where interest rate is lower! India 12%, US 7%.

Step 1
Borrow Rs 1000 at 12% rate for 6 months.

Step 2
Borrow Rs 1000 at 12% rate for 6 months and Convert into $ at SR. $1 = Rs 35.0020 You will get $ 28.56979

Step 3
Borrow Rs 1000 at 12% rate for 6 months and Convert into $ at SR. $1 = Rs 35.0020 You will get $ 28.56979

Place these $ in US market for 6 months at 7% annual rate.

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Step 3
Place these $ in US market for 6 months at 7% annual rate. You will get (after 6 months) = $ 28.5697*[(7 * 6/12 * 1/100) + 1] = $ 29.5696
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Step 4
Place these $ in US market for 6 months at 7% annual rate. You will get (after 6 months) =$ 29.5696

Now sell $29.5696 at Forward Rate. You will get Rs = $29.5696*35.9010 = Rs 1061.5782
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Step 5
Now sell $29.5696 at Forward Rate. You will get Rs = $29.5696*35.9010 = Rs 1061.5782

Refund the Borrowed money (Rs 1000) with interest 12%. Rs 1000*[(12 * 6/12 * 1/100) + 1] Rs 1060 Your gain = Rs 1061.5782 Rs 1060 = Rs 1.5782
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Exercise 2
An American firm purchases $4000 worth of goods from a French firm. The American distributor must make the payment in 90 days in French Franc. The following quotations and expectations exists for FFr: Present Spot Rate: $0.2000 per FFr US interest rate: 15% 90 days Forward Rate: $0.2200 per FFr French interest rate: 10%
continued .
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Exercise 2
Your expectation of the Spot Rate 90 days hence is: $0.2400 (A) How an arbitrager can get the advantage of the above situation? Assume (i) The arbitrager can borrow either $4000 or FFr 20000 and (ii) There is no transaction cost. (B) If the transaction cost is $50, review the arbitrage possibility.

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Important
1. 2. 3. 4. 5. 6. Start with opposite currency. Say Rs/$ is the case. And decision is to invest in $, so Borrow Rs. If decision was to invest in Rs, borrow $. It is not always necessary that we will invest in the country where interest rate is higher! IRD is absolute. ARP/D = [(FR-SR)/SR] * 12/k * 100, where k= forward months. If IRD> ARP/D, invest where Interest is Higher and vice versa.

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Exercise 3
Your company has to make a US$ 1 mn payment in 3 months time. The dollars are available now. You decide to invest them for three months and you are given the following information: the US deposit rate is 8% pa the sterling deposit rate is 10% pa the SR is $1.80 per the 3 months Forward Rate is $1.78 per

continued .

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Exercise 3
(A) Where should your company invest for better returns? (B) Assuming that the interest rates and the spot rate remain as above, what Forward Rate yield an Equilibrium situation. (C) Assuming that the US interest rate, the Spot Rate and Forward Rate remains as in the Original Question, where would you invest if the Sterling Deposit rate were 14% pa. (D) With the originally stated Spot and Forward Rates and the same dollar deposit rate, what is the 18 Equilibrium Sterling Deposit Rate?

(A) You have 2 alternatives

(I) Invest in $ (you already have US$ 1 mn) @ 8% pa for 3 months. (II) Convert $ into , place in London
Money Market for 3 months and enjoy interest @ 10% pa.

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Alternative (I)
1. Place $1mn @8% for 3 months. 2. You will get: $1000000[1+ (8/100)*(3/12)] = $1020000 Your gain $20000
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Alternative (II)
1. Convert $1mn into @ SR: 1=1.80; You will get (1000000/1.80) = 555555.60 2. Place 555555.60 in London Money Market @ 10 % for 3 months. You will get: 555555.60*[1+ (10/100)*(3/12)]= 569444.49 3. Convert 569444.49 into $ at Forward Rate(1=1.78) You will get $1013611.20 Your gain $13611.20
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Compare (I) and (II)

As in alternative (I), The gain is more so we will invest in alternative (I).

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(B) Equilibrium Forward Rate?

Equilibrium means, NO arbitrage possibility. Or, both the alternatives give same result or gain. How to find that Forward Rate?

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(B) Equilibrium Forward Rate?

How to find that Forward Rate? Check the calculations of Alt (I) and (II), Where Forward Rate came into picture?

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(B) Equilibrium Forward Rate?

How to find that Forward Rate? This was in the calculations of Alt (II), Where Forward Rate came into picture. And it was (1=1.78)

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(B) Equilibrium Forward Rate?

How to find that Forward Rate? Refer calculations of Alt (II) point (3), Convert 569444.49 into $ at Forward Rate(1=1.78).

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(B) Equilibrium Forward Rate?

This rate should be such so that the gain should be same as that of Alt (I), which was $20000. Meaning thereby, Conversion of 569444.49 [result of Alt (I)] into $ at Forward Rate say (1=x) Should give $1020000. So, 569444.49 *x = $1020000 and X = $1.791
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Equilibrium Forward Rate.

Its interpretation

1. As long as FR is lower than @1.791, it is beneficial to invest in US. 2. If it is more than 1.791, invest in London Money Market. 3. If it is exact 1.791, you can choose any of the alternatives.

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(C) if is changed to 14%

Refer calculation of Alt (II) part (2 and 3)
Place 555555.60 in London Money Market @ 10 % for 3 months. You will get: 555555.60*[1+ (10/100)*(3/12)]= 569444.49

Convert 569444.49 into $ at Forward Rate(1=1.78) You will get $1013611.20

In place of 10%, use 14% and redo the calculation.
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(C) if is changed to 14%

Refer calculation of Alt (II) part (2 and 3)
Place 555555.60 in London Money Market @ 14 % for 3 months. You will get: 555555.60*[1+ (14/100)*(3/12)]

Convert above into $ at Forward Rate(1=1.78) You will get $1023500.082

In place of 10%, use 14% and redo the calculation. This gain is now more than that of Alt (I)
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(D) Equilibrium rate?

Attempt in the same guideline!

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(D) Equilibrium rate?

Equilibrium rate means that interest rate which equals the gain in both the money markets. Let i= x% pa

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(D) Equilibrium rate?

Refer calculation of Alt (II) part (2 and 3)
Place 555555.60 in London Money Market @ 10 % for 3 months. You will get: 555555.60*[1+ (10/100)*(3/12)]*1.78 = 1013611.20

In above, interest rate, x, should be such so that right hand side is equal to 1020000.
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(D) Equilibrium rate?

Refer calculation of Alt (II) part (2 and 3)
Place 555555.60 in London Money Market @ x % for 3 months. You will get: 555555.60*[1+ (x/100)*(3/12)]*$1.78 = 1020000. x = 12.58%

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Interpretation
If i< 12.58 % pa, invest in US. If i> 12.58 % pa, invest in GB. If i= 12.58 % pa, US and GB are same.

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Exercise 4
Can $i = 9% US $i = 6.75% SR: Can$ = $0.9100 (in US) FR: Can $ = $0.9025 in 6-months. (A)Money will flow from which country to which country. (B)If a large numbers of operators do the arbitrage, what will be the effect upon (i) Spot Rate (ii) Forward Rate (iii) Interest Rate of both the countries.

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(A) Money will flow from which country to which country?

IRD = 2.25 ARD = [(0.9025-0.9100)/0.9100]*[12/6]*100 = 1.66% As IRD>ARD; Invest where i. is higher. Invest in 9% that is Canada. Money will flow from US to Canada.
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(B) What will happen to Spot Rate?

1. More of US$ will be converted into Can$.
2. Can$s demand will go up. 3. For each Can$, more US$ will be demanded. 4. Numerical value 0.9100 will go up. 5. Can$ will experience appreciation and USD will experience depreciation

SR: Can$=$0.9100

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(B) What will happen to FR?

Refer calculation no. 4 in next slide. Which currency is experiencing demand? USD SO, USD will appreciate. The numerical value 0.9025 will go DOWN!

FR: Can$=$0.9025

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(B) US interest rate?

$

6.75%

As many depositors will now withdraw Their money and take to Canada, Which US bank will not like; so for retaining $, bank will increase the Interest Rate.

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(B) CANADIAN interest rate?

Can$

9.00%

As many investors will now invest Their money and take to Canada, Which Can bank will like; so now they can comfortably decrease the Interest Rate.

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Arbitrage Gain
1. Borrow $1000 @ 6.75% pa for 6 months. You will have to pay $1033.75 after 6 months. 2. Convert into Can$ @SR. You will get Can$1098.90 3. Earn 9% interest for 6 months in Canadian Money Market. You will get Can$1148.35 4. Convert Can$1148.35 into USD @FR. You will get USD 1036.39 5. Refund the borrowed sum and have a clean gain of $2.64

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