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International Financial Management

ASSIGNMENT ON
INTERNATIONAL ARBITRAGE
AND
COVERED INTEREST RATE ARBITRAGE

Submitted to: Submitted By:
Prof. Deepak Tandon Vaibhav Sahu (113/09)

International Arbitrage & Covered Interest Arbitrage 1

Equity Arbitrage 8. TYPES OF ARBITRAGES 1. Merger Arbitrage 6. The same asset does not trade at the same price on all markets/ 2. Covered Interest Arbitrage 4. CONDITIONS FOR ARBITRAGE Arbitrage is possible when one of three conditions is met: 1. Two assets with identical cash flows do not trade at the same price.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. the profit being the difference between the market prices. Stock Arbitrage 9. Uncovered Interest Arbitrage 5. 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. 3. International Arbitrage & Covered Interest Arbitrage 2 . Fixed income Arbitrage etc. In academic use. Option Arbitrage 7. Currency Arbitrage 3. an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows.

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

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

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. strategic position.Currency arbitrage carried out by purchasing financial instruments in different currencies and using a Forward Exchange Contract to lock in a yield. they must also consider any losses or gains. geographical location. REASONS FOR CIA There is the difference between the interest rate of the different countries at any given point of time. The trade makes use of inconsistencies between interest rates and forward rates to make a risk-less profit. human resource development and various such factors. the investors cover against such partial losses by contracting for the future sale or purchase of a foreign currency in the forward market. When investors purchase the currency of a foreign country to take advantage of the higher interest rates abroad. 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. political situation. 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. While the forward rate and spot rate fluctuations occur due to fluctuations in demand and supply of a particular currency against the foreign currency. Generally. the changes in interest rate occur due to changes in borrowing and investments preferences of the investors in different countries. Such gains or losses might occur due to fluctuations in the value of the foreign currency prior to the maturity of their investment.

dollar interest rate = 4.2300.000)-1 = 5. the euro-denominated bond delivers EUR 1.260.200. • Exchange USD 1. Secondly.750. Alternatively. the two transactions can be viewed as resulting in an effective dollar interest rate of (1.025.000 into USD 1. agree to exchange the euros back into US dollars in 1 year at today's forward price. First. Had the investment been made in dollar. the forward contract turns the EUR 1. i.000.750/1.000 = USD 12. in this case.1. to receive USD 1.025.260.000.750. leaving an arbitrage profit of 1.260.e. euro interest rate = 2.0%. But.248. Forward USD/EUR for 1 year delivery = $1.5%.750 in 1 year. USD 1.260.1% • The above discussion does not consider the cost of capital.000 were borrowed at 4%. if the USD 1.248.000 would be owed in 1 year.000 into EUR 1. • At the expiry of one year. International Arbitrage & Covered Interest Arbitrage 6 .750 .2000.025.000 • Buy EUR 1. So. the return would have been only 4%.200.In this example the investor is based in the United States and assumes the following prices and rates: Spot USD/EUR = $1.000 via a 1 year forward contract.000 worth of euro-denominated bonds • Sell EUR 1.750.000.200. two transactions occur consecutively. the earning is USD 60. 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.

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

He will get 105 USD. convert receipts to foreign currency at spot rate.504GBP/USD.50 GBP/USD Forwards Rate = 0. The difference between the receipts and payments serve as profit to the customer. At the same time he will cover his principal and interest from this investment at the forward rate. both the options avail him similar return. invest in domestic currency denominated securities (as domestic securities carry higher interest). The difference between receipts and payments serve as profit to customer. At maturity. At maturity. foreign currency. International Arbitrage & Covered Interest Arbitrage 8 . At the same time he would cover his principal and interest from this investment at the forward rate. convert receipts to domestic currency at a prevailing rate ( Spot ). Thus. Currency denominated securities 9as Foreign Securities carry higher Interest). invest in for.Spot Rate = 0. LHS = (1+rh) RHS =F/S *(1+rf) When LHS is not = RHS à Arbitrage exists • If LHS <RHS --One would borrow home currency. • If LHS > RHS . he would convert the proceeds of the domestic investment at the prefixed domestic forward rate and payoff the foreign liability.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.One would borrow . he would convert the proceeds of the foreign investment at a prefixed forward rate and payoff the domestic liability.

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

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

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