International Financial Management

ARBITRAGE
Arbitrage involves no risk and no capital of your own. It is an activity that takes advantages of
pricing mistakes in financial instruments in one or more markets. This opportunity for risk less
profit arises when the currency's exchange rates do not exactly match up. As you recall, arbitrage
refers to the process by which an individual purchases a product ( in this case foreign exchange)
in a low-priced market for resale in a high-priced market for the purpose of making a profit. In
the process, the price is driven up in the low-priced market and down in the high-priced market.
This activity will continue until the prices in the two markets are equalized, or until they differ
only by the transaction costs involved. Because currency is being bought and sold
simultaneously, there is no risk in this activity and hence there are always many potential
arbitragers in the currency market.
There are 3 kinds of arbitrage
1) Local (sets uniform rates across banks)
2) Triangular (sets cross rates)
3) Covered (sets forward rates)
Note: The definition we used presents the ideal view of (riskless) arbitrage. “Arbitrage,” in the
real world, involves risk. We’ll call this arbitrage pseudo arbitrage.
[Note: We will discuss the covered interest arbitrage in chapter 4]
Local Arbitrage (One good, one market)
Example: Suppose two banks in Dhaka have the following bid-ask FX quotes:
Bank A Bank B
Bid Ask Bid Ask
BDT/GBP 131 132 134 135
Sketch of a Local Arbitrage strategy:
(1) Borrow 132 BDT
(2) Buy 1 GBP for 132 BDT from Bank A
(3) Sell 1 GBP to Bank B for 134
(4) Return BDT 132 and make a profit of 2 taka (1.51% per GBP on 132 taka borrowed)
Note I: All steps should be done simultaneously. Otherwise, there is risk! (Prices might change).
Note II: Bank A and Bank B will notice a book imbalance. Bank A will see all activity at the ask side
(buy GBP orders) and Bank B will see all the activity at the bid side (sell GBP orders). They will
notice the imbalance and they’ll adjust the quotes. For example, Bank A can increase the ask quote to
134 BDT/GBP which will cancel any arbitrage opportunity.
TRIANGULAR ARBITRAGE
Triangular arbitrage is a process where two related goods set a third price. The typical process of
a triangular arbitrage is converting one currency to another, converting it again to a third
currency and, finally, converting it back to the original currency within a short time span. In the
FX market, triangular arbitrage sets FX cross rates. Cross rates are exchange rates that do not
involve the USD. Most currencies are quoted against the USD. Thus, cross-rates are calculated
from USD quotations.
The cross-rates are calculated in such a way that arbitrageurs cannot take advantage of the
quoted prices. Otherwise, triangular arbitrage strategies would be possible. Triangular arbitrage

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opportunities do not happen very often and when they do, they only last for a matter of seconds.
Traders that take advantage of this type of arbitrage opportunity usually have advanced computer
equipment and/or program to automate the process. Simply, triangular arbitrage process involves
the following steps:-
 Acquiring the domestic currency
 Exchange the domestic currency for the common currency
 Convert the obtained units of the common currency into the second (other) currency
 Convert the obtained units of the other currency into the domestic currency.
Let’s take a look at an example, which we’ll make easier by not considering the bid- ask spreads.
Assume the following three sets of hypothetical quotes:
New York: USD/CAD = 1.1651
Frankfurt: CAD/CHF = 1.1176
London: USD/CHF = 1.3008
Arbitrageurs would find that there are discrepancies among these quotes. To capitalize on these
discrepancies, the arbitrageur may take the following steps:
 
Sell 1,000,000 USD and buy 1,165,100 CAD in New York
(Remember, if we exchange the base currency for the quote currency we multiply by the quote.)
Sell the 1,165,100 CAD and buy 1,302,116 CHF in Frankfurt
(Again, moving from CAD to CHF we must multiply by the quote.)
Sell 1,302,116 CHF and buy 1,001,012 USD in London
(As we move from quote currency to base currency we must divide by the quote.)
These actions can be better understood by Figure 2.4, which demonstrates the process of
triangular arbitrage:

Figure 2.4: Triangular Arbitrage.

The arbitrageur nets a profit of $1,012 by going through the above three legs of the triangle. In
reality, each step will not be taken individually as the arbitrageur would be exposed to execution
risk – the risk of the quotes moving adversely during the time to set up the next trade. Instead,
once the computer program flags the opportunity, arbitrageur would enter the following trades
simultaneously:
 

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1. Sell 1,000,000 USD/CAD in New York

2. Sell 1,165,100 CAD/CHF in Frankfurt
3. Buy 1,001,102 USD/CHF in London
These actions put the following pressures into action:
1. Selling pressure on the USD in New York. The quote will eventually FALL below
USD/CAD = 1.1651
2. Selling pressure on the CAD in Frankfurt. The quote will eventually FALL below CAD/CHF
= 1.1176
3. Buying pressure on the USD in London. The quote will eventually RISE above USD/CAD =
1.3008
Problem 2.19: If you find 1 USD equals to 85 BDT and 1 EUR equals to 1.2 USD and you have
found 1 Euro is trading for 110 BDT. Suppose if you can borrow one million BDT how much
money can you make out of conducting one arbitrage? Please draw a diagram.
Solution: We first need to find the cross rate of BDT/EUR whether it is 110 BDT per EUR or
not. If it is then there is no arbitrage opportunity but if not then we will conduct a triangular
arbitrage.

BDT = BDT x USD = 85 x 1.2 = 102 BDT/EUR. It is less than 110 which is in the market.
EUR USD EUR
1078431.373 – 1000000
=PROFIT 78431.373 BDT

START: 1000000 BDT

SELL €9803.92 & BUY Sell 1000000 BDT and buy

1078431.373 BDT $11764.706 ($1= 85 BDT)
(€1=110BDT) The process of

Triangular
Arbitrage
€9803.92
$11764.70
SELL $11764.706 AND BUY
€9803.92 ($11764.7/1.2)

Starting with 1 million BDT arbitraging, an arbitrager makes 78431.373 BDT from 1 arbitrage.
Problem 2.20: If you find 1 USD equals 86.5 BDT and 50 INR but you have also found 1 INR is
trading for 1.6 BDT. If you can borrow 1 million BDT, how much money can you make from
one arbitraging? Please draw a diagram.
Solution:
Here, BDT/USD = 86.5
INR/USD = 50

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So BDT/INR should be BDT/INR = BDT/USD x USD/INR

= 86.5 x 1/50
= 1.73 BDT per INR.
But in the market it is trading at 1.6 BDT per INR. Obviously we can conduct an arbitrage.

(1081250 – 1000000) =
PROFIT 81250 BDT

START: 1000000 BDT

SELL 1000000 BDT & BUY

SELL 12500 USD & BUY 625000 INR (1000000/1.6)
1081250 BDT (12500 x
86.5) The process of

Triangular arbitrage

12500 USD 625000 INR

SELL 625000 INR & BUY
12500 USD (6250000/50)

Starting with one million BDT arbitraging, an arbitrager will make 81250 BDT from single
arbitrage.
Note: Before conducting triangular arbitraging you need to confirm whether there is an
opportunity of doing it by finding the cross rate and if you find the cross rate is higher or lower
the market rate only then you can start the process of triangular arbitrage.
Problem 2.21: Suppose that the forward ask price for March 20 on Euros is $0.9127 at the same
time that the price of CME euro futures for delivery on March 20 is $0.9145. How could an
arbitrageur profit from this situation? What will be the arbitrageur's profit per futures contract
(contract size is € 125,000)?
Solution: Since the futures price exceeds the forward rate, the arbitrageur should sell futures
contracts at $0.9145 and buy euro forward in the same amount at $0.9127. The arbitrageur will
earn 125,000(0.9145 - 0.9127) = $225 per euro futures contract arbitraged.

COVERED INTEREST ARBITRAGE

Covered Interest Arbitrage is basically the movement of the short terms funds between two
countries for taking the advantage of the interest rate differences along with exchange risks
which are covered by the forward contracts. The investors when purchases the foreign currency
to take the profit from the interest rate differentials then he must always be ready to take the risks
of the fluctuations in the foreign currency and the losses due to it. These losses or gains primarily
occur due to the movement of the foreign currency or the fluctuations in the currency. To cover
the same or to hedge themselves from these losses the investor does that he equalizes the entire

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transaction with the purchase or sale of the foreign currency in the forward market, and this leads
to hedging and now whatever may be the fluctuations, whatever may be the differences in the
interest rates and the currency rates, the investors profit and losses are now hedged and it would
be the same, though there are huge differences in the market. That’s why it is called covered
since it covers the future uncertainty.

The Interest Rate Parity theory suggests that any amount of exchange gains and losses incurred
by the investor by simultaneously purchasing and selling in the spot and the forward markets, are
generally offset by the interest rates differences on the similar type of assets. Under the said
condition there is basically no incentive for the amount or capital to move in either direction
because the total effective returns in the domestic market and the foreign market has equalized or
came to equilibrium.

Basically, this theory says that whenever there are differences in the forward and the spot rates
with the differences in the interest rates between the two countries an arbitrage is possible and
the covering of this sort of Arbitrage is referred to as Covered Interest Arbitrage. An arbitrageur
would do the following: He would borrow in foreign currency, convert receipts to domestic
currency at the prevailing spot rate, and invest in domestic currency denominated securities (as
domestic securities carry higher interest). At the same time he would cover his principal and
interest from this investment at the forward rate. At maturity, he would convert the proceeds of
the domestic investment at prefixed domestic forward rate and payoff the foreign liability. The
difference between the receipts and payments serve as profit to customer.

So, to get the idea of covered interest Arbitrage the following steps are essential.

1. Firstly, the investor has to borrow the currency which as per the Interest Rate Parity has
the lower interest rates.
2. After borrowing the currency having the lower interest rates, one has to calculate the
payables at the end of the maturity period due to this borrowing.
3. Again now the amount which has been borrowed has to be converted in the other
currency (which has not been borrowed), it means that the borrowed amount shall be converted
into the other currency.
4. Now, the converted amount of the currency has to be invested in the prevailing interest
rates, obviously it is such that the interest rates are higher at the time of investing in the other
currency.
5. After the investment process is done, we have to calculate the amount of the receivables
after the maturity of the investments basically in the higher interest rates.
6. Then we have to convert the receivables realized in the currency in which the borrowing
has been made using the forward market which was locked to calculate the amount of gain or
losses.
7. Now we have to compare the step 2, (here the payables where calculated on maturity) and
step 6, (here the receivables are calculated) and we would see that the amount received in step 6
would be higher than the amount received in step 2.

This is basically what we refer to as a Covered Interest Arbitrage as all the conditions were fixed
at the time of making the borrowings and in there are favorable fluctuations in the market then

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the investor can enjoy much more gains due to this. But factually, this fluctuation is for splits of
time because a large number of investor comes to take the profit margin and then the interest
rates and the currency rates comes to equilibrium, decreasing the arbitrage to a no arbitrage
situation.

Example: If the borrowing rate (interest) in Japan is only 3% and Bangladesh government’s
saving bonds pay 13.25% annual interest and one year forward rate between Yen and taka is1.11
taka per yen which is currently on the spot exchanging for 1.04 BDT per yen. Can you conduct a
covered interest arbitrage?

Before conducting an arbitrage we have to check whether it holds the IRP theory or not.
According to IRP the interest rate differentials between Japan and Bangladesh is 10.25%
whereas the yen is selling for 6.73% premium only which should have been more than 10% to
maintain the IRP. So a covered interest arbitrage is possible. Here are the 7 steps below:

Step 1: The investor has to borrow yen at 3%. Say he/she borrowed 1 million yen at 3% from a
Japanese bank since it offers the lower interest rate.
Step 2: Now he/she has to calculate the payable after 1 year which is 1.03 million yen.
Step 3: Now the 1 million yen has to be converted at the spot rate of 1.04 BDT per 1 yen which
will be 1.04 million BDT.
Step 4: Now this 1.04 million BDT is invested at risk free Bangladesh government’s savings
bond at 13.25% interest rate per year.
Step 5: After 1 year the investor will receive 1.1778 million BDT including interest.
Step 6: This 1.1778 million BDT has to be converted to Japanese yen which was locked using
the one year forward market at 1.11 BDT per yen which will give 1.061081 million yen.
Step 7: The arbitrageur will make (1.06081 – 1.03) million or 0.03081 million yen after paying
his 1.03 million yen payable to the Japanese bank.

Another example:
$ Interest rate = 2% for 90 days in US. £ Interest rate = 3% for 90 days in UK
Spot $/£ = 1.50 90 day forward $/£ = 1.50
Arbitrageur does the following:
Step I Borrow $1.50 million in US for 90 days.
Step II Calculate the payable after 90 days
Step III Convert to £ at the prevailing spot rate Le. 1.50 to get £1 million
Step IV Buy 90 days Deposit at UK Bank yielding 3% for 90 days.
Step V Sell £1.03 million forward [£1 million + £0.03 million interest on deposit] at forward rate
of 1.50 per £.
Step VI At maturity he gets £ 1.03 million
Step VII Against his forward contract selling which he has booked he would get
707 ____________ ______________________________
1.50 × £ 1.03 = $1.545 million dollars.

Compare this with 1.50 × 1.02= $1.530 million dollars he would have got by depositing directly
in US deposits. Thus he made a profit of $1.545 – $1.530 = 0.015 million dollars i.e. $15000.

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Uncovered arbitrage is much the same, except that at the start they do not enter into a contract
for a forward exchange rate back, meaning that they just have to invest back at the spot rate that
is available to them at the end of the year long investment. This is no-where near as safe, but
contrary to this there is a chance that the spot exchange rate at the end may be considerably
higher or lower depending upon the market at the time and therefore meaning that an uncovered
arbitrage may end up making you considerably more money, or the exact opposite.

[Note: Whether the term could be used as uncovered interest arbitrage since arbitrage means
riskless profit and with the uncovered interest arbitrage method there is no guarantee a profit will
be made and there is also risk involved since not knowing the future spot rate at the time of
investment. On the BDT and yen example if the investor didn’t buy the forward contract of yen
which is selling at 6.73% premium he/she would be uncovered which means the BDT could be
exchanged against yen at any rate and thus he/she is exposed to currency risk and if it is
exchanged for 1.25 BDT per yen then the investor will incur a significant amount of loss.]

Still let’s examine what is an uncovered interest arbitrage. Uncovered interest arbitrage is the
notion that the forward exchange rate is an unbiased estimate of the future spot rate.
Uncovered interest arbitrage assumes that, on average, an investor who borrows in a low interest
rate country, converts the funds to the currency of a high interest rate country, and lends in that
country will not realize a profit or suffer a loss. It follows from uncovered interest arbitrage that
the expected return of a forward contract equals 0 percent.