Name : Devi Nanda Bayti Rahma

NIM : C1B018095
Task : Summary Chapter 7
International Arbitrage and Interest Rate Policy
International Arbitrage
Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices to make a riskl
ess profit. The effect of arbitrage on demand and supply is to cause prices to realign, such that no furt
her risk-free profits can be made.
As applied to foreign exchange and international money markets, arbitrage takes three common f
orms:
1. locational arbitrage
2. triangular arbitrage
3. covered interest arbitrage

Locational Arbitrage
Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another ba
nk’s selling price (ask price) for the same currency.

Triangular arbitrage
Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated
from spot rate quotes.

Covered Interest Arbitrage

Covered interest arbitrage is the process of capitalizing on the interest rate differential between t
wo countries while covering for exchange rate risk. Covered interest arbitrage tends to force a relatio
nship between forward rate premiums and interest rate differentials.
Example:
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
Borrow $ at 3%, or use existing funds which are earning interest at 2%. Convert $ to £ at $1.60/£ and
engage in a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%.
Note: Profits are not achieved instantaneously.

Assume you have USD for 90 d

Swiss franc interest rate 4.00% p.a.
US $ interest rate 8.00 % p.a.
Spot rate = CHF/$, 90 day forward = CHF/$
Is arbitrage possible ?

Interest Rate Parity

Interest Rate Parity

Interest Rates and Exchange Rates

A deviation from covered interest arbitrage is uncovered interest arbitrage (UIA). In this case, in
vestors borrow in countries and currencies exhibiting relatively low interest rates and convert the pro
ceed into currencies that offer much higher interest rates. The transaction is “uncovered” because the
investor does no sell the higher yielding currency proceeds forward, choosing to remain uncovered a
nd accept the currency risk of exchanging the higher yield currency into the lower yielding currency
at the end of the period.
Assume spotrate for Yen is Y120/$, Yen interest is 0.4% p. a., $ interest is 5 % p.a., Y Expected spot
rate in 1 year is also Y120/$

Uncovered Interest Arbitrage (UIA): The Yen Carry Trade

Interest Rate Parity (IRP)
As a result of market forces, the forward rate differs from the spot rate by an amount that sufficie
ntly offsets the interest rate differential between two currencies. Then, covered interest arbitrage is n
o longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).

Derivation of IRP
We use the following symbols
a) Amount of home currency invested initially is Ah which grows to An after investing in forei
gn deposit
b) Spot rate (direct quote) is S and forward rate F
c) Interest rate is ih at home and if in the foreign country
d) Return on investing abroad is R

Derivation of IRP
We have that An = (Ah/S) ● (1+if) ● F
Since F = S ● (1 + p) where p is forward premium, we have that
An = (Ah/S) ● (1+if) ● [S ● (1 + p)]
An = Ah ● (1+if) ● (1 + p)
R = (An – Ah)/Ah

Derivation of IRP
For IRP to hold domestic and foreign returns are equal, i.e. R = ih
Interest Rate Parity Defined
Or if you prefer,

Determining the Forward Premium

Example:
Suppose 6-month ipeso = 6%, i£ = 5%.
From the U.K. investor’s perspective,
forward premium = 1.05/1.06 – 1 
If S = £.07/peso, then
6-month forward rate = S  (1 + p)
 =.07  (1 _ .0094)
 =£.06934/peso

Graphic Analysis of Interest Rate Parity

Graphic Analysis of Interest Rate Parity (2)

Test for the Existence of IRP
To test whether IRP exists, collect actual interest rate differentials and forward premiums for var
ious currencies, and plot them on a graph. IRP holds when covered interest arbitrage is not possible o
r worthwhile.

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

Does IRP Hold? (1)

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

Considerations When Assessing IRP