International Financial Management

ASSIGNMENT ON INTERNATIONAL ARBITRAGE AND COVERED INTEREST RATE ARBITRAGE

Submitted to:
Prof. Deepak Tandon

Submitted By:
Vaibhav Sahu (113/09)

International Arbitrage & Covered Interest Arbitrage

1

Option Arbitrage 7. TYPES OF ARBITRAGES 1. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate. International arbitrage 2. International Arbitrage & Covered Interest Arbitrage 2 . Equity Arbitrage 8. The same asset does not trade at the same price on all markets/ 2. Two assets with identical cash flows do not trade at the same price. the profit being the difference between the market prices. CONDITIONS FOR ARBITRAGE Arbitrage is possible when one of three conditions is met: 1. Currency Arbitrage 3. Fixed income Arbitrage etc. 3. Covered Interest Arbitrage 4.ARBITRAGE Aarbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance. Uncovered Interest Arbitrage 5. Merger Arbitrage 6. In academic use. Stock Arbitrage 9. an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows.

The difference in the two markets is pure profit. The investor then turns to the market where it is selling higher and sells it. International arbitrage is widely seen as a little to no-risk investment.INTERNATIONAL ARBITRAGE The practice of buying and selling a security registered in a foreign country and an International Depositary Receipt based on that same security. This allows the arbitrageur to profit from inefficiencies in price resulting from the exchange rate. as the initial purchase doesn’t take place unless the profit is available right then. International arbitrage revolves around taking advantages of price differences between goods and securities in different countries. but what it lacks in complexity it makes up for in timing. High turnover goods. While this is a common practice among many types of investors. they are selling that same item in a different market. This bubble will cause the good to have a higher or lower value than elsewhere. like monetary investments. but not in others. will often have small surges in one area. In a typical arbitrage situation. This surge will translate through the system. Since international arbitrage relies on the buying and selling at nearly the same time. International arbitrage follows a fairly simple process. When the broker is purchasing an item in one market. and other factors. When they see that a specific stock. the difference in price on different exchanges. the investor is monitoring one good on multiple markets. arbitrage separates itself because the buying and selling happen nearly simultaneously. this process has increased as computers and technology allow for instant International Arbitrage & Covered Interest Arbitrage 3 . but it will often create a small bubble in the original market. they purchase it at the lower price. This investment method relies on multiple markets in vastly different locations. Even though most investment markets are tied together by computer. that doesn’t stop small discrepancies from popping up in the system. commodity or monetary bond is selling at a different rate in one market.

and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. This requires a nearly instant purchase and sale. While international arbitrage seems like a no-fail type of investing. If any part of the communication chain falters or lags. they need to act immediately before it closes. When an investor sees the market imbalance. International Arbitrage & Covered Interest Arbitrage 4 . even a few seconds could disrupt the sale. Since market imbalances are often very short-lived.communication. The entire system centres on the speed of communication between the buyer and seller. something that was impossible before the communication systems became global. COVERED INTEREST ARBITRAGE Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency. there is a small element of risk. then the seller may not capitalize on the proper price.

Generally. REASONS FOR CIA There is the difference between the interest rate of the different countries at any given point of time. political situation. geographical location. strategic position. The strategy of Covered Interest Arbitrage exist as an exploitation of the International Fischer Equation and Interest Rate parity between any two countries while covering the risk using the instrument of forward or future contract. CIA is the movement of short term funds between countries to take advantage of interest differentials with the exchange risk covered by the forward contracts. EXAMPLE International Arbitrage & Covered Interest Arbitrage 5 . This difference occur due to differences in phases of growth of economies.Currency arbitrage carried out by purchasing financial instruments in different currencies and using a Forward Exchange Contract to lock in a yield. While the forward rate and spot rate fluctuations occur due to fluctuations in demand and supply of a particular currency against the foreign currency. Such gains or losses might occur due to fluctuations in the value of the foreign currency prior to the maturity of their investment. When investors purchase the currency of a foreign country to take advantage of the higher interest rates abroad. they must also consider any losses or gains. the investors cover against such partial losses by contracting for the future sale or purchase of a foreign currency in the forward market. human resource development and various such factors. The trade makes use of inconsistencies between interest rates and forward rates to make a risk-less profit. These fluctuations result in the arbitrage opportunity being done for a very limited period after which interest rates and the exchange rates adjust to nullify the effect. the changes in interest rate occur due to changes in borrowing and investments preferences of the investors in different countries.

• • • Exchange USD 1. Forward USD/EUR for 1 year delivery = $1.750 in 1 year.000.0%.000 would be owed in 1 year. Alternatively.000 worth of euro-denominated bonds Sell EUR 1. the euro-denominated bond delivers EUR 1. International Arbitrage & Covered Interest Arbitrage 6 . • At the expiry of one year. USD 1.000 Buy EUR 1.2300.750. if the USD 1.200. i. The strategy of Covered Interest Arbitrage exist as an exploitation of the International Fischer Equation and Interest Rate parity between any two countries while covering the risk using the instrument of forward or future contract.260. two transactions occur consecutively. euro interest rate = 2.750.000 via a 1 year forward contract.000.750 .5%. in this case. the return would have been only 4%.025.248.000 into USD 1. Had the investment been made in dollar. leaving an arbitrage profit of 1.248. the forward contract turns the EUR 1.2000. First.200. So.260.000 = USD 12. Secondly.1% • The above discussion does not consider the cost of capital.1. to receive USD 1.200. dollar interest rate = 4.In this example the investor is based in the United States and assumes the following prices and rates: Spot USD/EUR = $1. the two transactions can be viewed as resulting in an effective dollar interest rate of (1.000 were borrowed at 4%.000)-1 = 5.000 into EUR 1.025.750/1.260.025.260.750. the earning is USD 60.000. agree to exchange the euros back into US dollars in 1 year at today's forward price. But.e.

the forwards rates discount or premium for the foreign currency. Whenever there is fluctuation on one side. In other words. should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. Thus. Mathematically. exchanging that currency for another currency and investing in interest-bearing instruments of the second currency.INTERNATIONAL FISCHER EQUATION The relationship between the foreign exchange market and the money markets is established by the International Fischer Equation. both the actions should lead to the same return at all points of time. Thus. The RHS of this equation should balance the LHS of the equation generally. for International Fischer equation to be true. but opposite in sign to. the other changes to compensate for the change and thus balance the equation. while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period. any gain or loss incurred by the investor in simultaneous transaction in spot and forward market is offset by interest rate differential in two countries. the returns from borrowing in one currency. The difference in the national interest rates for securities of similar risk and maturity should be equal to. Example: US interest rate= 5% UK interest rate = 4% International Arbitrage & Covered Interest Arbitrage 7 . the International Fischer Equation is established as: Where i$ = interest rate in foreign country F= forward rate S= Spot rate ic = Interest rate in home country.

convert receipts to foreign currency at spot rate. he would convert the proceeds of the domestic investment at the prefixed domestic forward rate and payoff the foreign liability. • If LHS > RHS . he would convert the proceeds of the foreign investment at a prefixed forward rate and payoff the domestic liability. invest in for.50 GBP/USD Forwards Rate = 0.Spot Rate = 0. both the options avail him similar return.One would borrow . LHS = (1+rh) RHS =F/S *(1+rf) When LHS is not = RHS • If LHS <RHS Arbitrage exists --One would borrow home currency. The difference between the receipts and payments serve as profit to the customer. Thus. International Arbitrage & Covered Interest Arbitrage 8 . At maturity. invest in domestic currency denominated securities (as domestic securities carry higher interest). foreign currency. He will get 105 USD. convert receipts to domestic currency at a prevailing rate ( Spot ).504GBP/USD. The difference between receipts and payments serve as profit to customer. Currency denominated securities 9as Foreign Securities carry higher Interest). At maturity. At the same time he would cover his principal and interest from this investment at the forward rate. At the same time he will cover his principal and interest from this investment at the forward rate.504 GBP/USD The investor has two options Option 1: To invest money in US market @5% to earn 105 at the end of the year Option 2: To convert 100 USD into GBP (200GBP) and invest in UK market @ 4% to earn 216 GBP after an year and then convert it into USD at the forward rate of 0.

International Arbitrage & Covered Interest Arbitrage 9 . Looked at differently.INTEREST RATE PARITY Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency. When IRP exist. should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period. or futures price. an arbitrage transaction could. produce a riskfree return. in theory. of a currency incorporate any interest rate differentials between the two currencies assuming there are no transaction costs or taxes. If the returns are different. exchanging that currency for another currency and investing in interest-bearing instruments of the second currency. interest rate parity says that the spot price and the forward. the rate of return achieved from CIA should equal the rate of return available in home country.

interest rate in US is low because it’s the safest and developed economy in the world. we can say that p= [(1+i$)/(1+ic)] .1 = [(i$. Apart from that. the government is stable.ic. It simple means that investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries. RHS = [{SX(1+p)}/S] * (1+ic) = (1+ic) * (1+p) Where p = forward premium From IFE. has good human resource development. These factors increase the riskiness of the investment who therefore seeks higher returns. has feasible investment options and is a hub for new technological advancements with many world organizations headquartered in its major cities.ic)/(1+ic)] In approximated form. For example. such as transaction costs. bad human resource development. provides a reasonable estimate when the interest rate differential is small. higher prospect of terrorist attacks and killings. follows Capitalistic form of governance and has agreeable trade allowances. Afghanistan has high interest rate because of the unstable government. The deviations from Interest Rate Parity occur due to characteristics of foreign investments. International Arbitrage & Covered Interest Arbitrage 10 . Also. discourages foreign investments. It is clear that Interest Rate Parity hold when the Covered Interest Arbitrage does not exist.Going back to International Fischer Equation. weak economy. In contrast to that. it does not mean that both local and foreign investors will earn the same returns. poor technological advancement. political risk and differential tax laws. when Interest Rate Parity exists. p = i$.

following changes will happen: 1. Interest rates of domestic country will rise 2. • Covered Interest Arbitrage is the exploitation of the IRP and is used and can be used by the investors only for the short term investments. International Arbitrage & Covered Interest Arbitrage 11 .ARBITRAGE CORRECTION Arbitrage opportunity does not remain available for a long period. • If there are changes in the interest rates in one country. Interest rates of foreign currency will fall 3. Forward rate will fall. Spot rate will become high 4. If RHS>LHS. CONCLUSION • The International Fischer equation explains why investments across the world are balanced. • The differences in interest rate of different countries occur to capture the risk profile of different economies. Market forces correct to make a balance (Fischer Equation). other countries are also bound to make a change in their interest rates to avoid huge demand for one particular currency.

Sign up to vote on this title
UsefulNot useful