# Chapter

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.

7-2

such that no further risk-free profits can be made. 7-3 .International Arbitrage • Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices to make a riskless profit. • The effect of arbitrage on demand and supply is to cause prices to realign.

International Arbitrage • As applied to foreign exchange and international money markets. arbitrage takes three common forms: ¤ ¤ ¤ locational arbitrage triangular arbitrage covered interest arbitrage 7-4 .

635 \$.640 Bank D Bid Ask NZ\$ \$.Locational Arbitrage • Locational 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.005/NZ\$. Profit = \$.650 Buy NZ\$ from Bank C @ \$.645.645 \$.640. Example Bank C Bid Ask NZ\$ \$. 7-5 . and sell it to Bank D @ \$.

10/£.200/MYR = \$1.200.200 MYR8.10/£  \$.61.62/£ Buy £ @ \$1.20 MYR8.202 MYR8.60 \$. convert @ MYR8. 7-6 .01/£. Profit = \$.10 Ask \$1.61 \$. then sell MYR @ \$. Example British pound (£) Malaysian ringgit (MYR) British pound (£) Bid \$1.Triangular Arbitrage • Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes.

• Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials.Covered Interest Arbitrage • Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering for exchange rate risk. 7-7 .

90-day interest rate = 4% Borrow \$ at 3%. 90-day interest rate = 2% U.60 U. or use existing funds which are earning interest at 2%.60/£ and engage in a 90-day forward contract to sell £ at \$1.S.K. Note: Profits are not achieved instantaneously. 7-8 . Convert \$ to £ at \$1. Lend £ at 4%.Covered Interest Arbitrage Example £ spot rate = 90-day forward rate = \$1.60/£.

thus making the foreign exchange market more orderly.Comparing Arbitrage Strategies • Any discrepancy will trigger arbitrage. 7-9 . which will then eliminate the discrepancy.

the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies. covered interest arbitrage is no longer feasible. and the equilibrium state achieved is referred to as interest rate parity (IRP).Interest Rate Parity (IRP) • As a result of market forces. • Then. 7 .10 .

7 .Derivation of IRP • When IRP exists. • 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.11 . the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country.

forward = (1 + home interest rate) – 1 premium (1 + foreign interest rate) 7 .12 .e.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.

i\$ = 5%.Determining the Forward Premium Example • Suppose 6-month ipeso = 6%.05/1.06 – 1  . then 6-month forward rate = S  (1 + p) _  . forward premium = 1.10/peso.13 .0094)  \$.09906/peso 7 ..S.0094 • If S = \$. investor’s perspective.10  (1 . • From the U.

provides a reasonable estimate when the interest rate differential is small.14 .Determining the Forward Premium • 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. 7 .

2 covered interest arbitrage by local investors -4 7 .15 .Graphic Analysis of Interest Rate Parity Interest Rate Differential (%) home interest rate – foreign interest rate 4 Zone of potential covered interest IRP line arbitrage by foreign investors 2 Forward Discount (%) -3 -1 1 3 Forward Premium (%) Zone of potential .

collect actual interest rate differentials and forward premiums for various currencies. 7 .16 . and plot them on a graph. • IRP holds when covered interest arbitrage is not possible or worthwhile.Test for the Existence of IRP • To test whether IRP exists.

Interpretation of IRP • When IRP exists. it does not mean that both local and foreign investors will earn the same returns.17 . • What it means is that investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries. 7 .

Does IRP Hold? Forward Rate Premiums and Interest Rate Differentials for Seven Currencies 7 .18 .

political risk. such as transaction costs. 7 . they are often not large enough to make covered interest arbitrage worthwhile.19 . • While there are deviations from IRP.Does IRP Hold? • Various empirical studies indicate that IRP generally holds. • This is due to the characteristics of foreign investments. and differential tax laws.

Considerations When Assessing IRP Transaction Costs 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 p 7 .20 .

S.Annualized interest rate 8% 8% 6% 6% 4% 2% 0% Changes in Forward Premiums i€ Euro’s interest rate i\$ U. interest rate Q1 4% 2% 0% Q3 Q1 Q3 Q1 i > i 2000 2001 \$ € 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 premium 2000 2001 2% 0% Q3 Q1 2002 Q3 Q1 2003 Q3 discount -2% Q3 Q1 Q3 Q1 Q3 Q1 Q3 7 .21 2000 2001 2002 2003 .