Professional Documents
Culture Documents
Chapter 07
Chapter 07
7
International Arbitrage And
Interest Rate Parity
7. 1
7. 2
7. 3
Chapter Objectives
7. 4
International Arbitrage
Arbitrage can be defined as capitalizing on a
discrepancy in quoted prices to make a risk-free
profit.
International Arbitrage
As applied to foreign exchange and international
money markets, international arbitrage (i.e., taking
risk-free positions by buying and selling currencies
simultaneously) takes three major forms:
locational arbitrage
triangular arbitrage
covered interest arbitrage
7. 6
Locational Arbitrage
Locational arbitragers try to offset spot bid-ask
exchange rate disequilibrium
Bid
Ask
Bank D
Bid
Ask
NZ$
$.635
$.640
NZ$
$.645
$.650
Triangular Arbitrage
Triangular arbitragers try to offset cross-rate
disequilibrium
Bid
Ask
$1.60
$1.61
$.200
$.201
MYR8.10
MYR8.20
MYR8.00
MYR8.01
7. 8
7. 9
Triangular Arbitrage
US$
Value of
in $
Value of
MYR in $
MYR
Value of
in MYR
When the actual and calculated cross exchange
rates differ, triangular arbitrage will force them
back into equilibrium.
7. 11
7. 12
Capitalizes on discrepancies in
exchange rates across locations.
$/ quote
by Bank X
$/ quote
by Bank Y
7. 14
Capitalizes on discrepancies in
cross exchange rates.
/ quote
by Bank A
$/ quote
by Bank B
$/ quote
by Bank C
7. 15
Capitalizes on discrepancies
between the forward rate and the
interest rate differential.
Forward rate
of quoted in
dollars
Differential
between U.S.
and British
interest rates
7. 16
7. 17
7. 18
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.
= (1/S) (1+iF) F
7. 19
Derivation of IRP
End-value of a $1 investment in the home country = 1 + iH
Equating the two and rearranging terms:
(1+iF) (1+p) = 1 + iH
(1+iH)
(1+iF)
i.e.
forward
premium
1
7. 20
= S (1 + p)
.10 (1
.0094)
$.09906/peso
7. 21
S(1+p) S
S
=p=
(1+iH)
(1+iF)
1=
(iHiF)
(1+iF)
7. 22
-3
Y
IRP line
Z
B
1
-1
3 Forward
Premium of
FC(%)
-2
A
W
-4
7. 23
-3
-1
3 Forward
Premium of
FC (%)
-2
-4
Zone of potential
covered interest
arbitrage by
local investors
7. 24
7. 25
Interpretation of IRP
When IRP exists, it does not mean that both local
and foreign investors will earn the same returns.
7. 26
7. 27
7. 28
IRP line
Zone of
potential
covered
interest
arbitrage
by local
investors
7. 29