International Financial MGMT U2

UNIT 2 i
The relationship between exchange rates, interest rates and inflation
Unit 2
BBF 308/05
International Financial
Management
The Relationship
between Exchange
Rates, Interest Rates
and Inflation
ii WAWASAN OPEN UNIVERSITY
BBF 308/05 International Financial Management
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EXTERNAL COURSE ASSESSOR

Associate Professor Dr. Law Siong Hook, Universiti Putra Malaysia
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UNIT 2 iii
Contents
Unit 2 The Relationship between
Exchange Rates, Interest Rates
and Inflation
Unit overview 1
Unit objectives 1
2.1 International arbitrage and realignments 3
Objectives 3
Introduction 3
The concept of arbitrage 3
Locational arbitrage 4
Triangular arbitrage 7
Covered and uncovered Interest arbitrage 9
Suggested answers to activities 16
2.2 The theory of interest rate parity 19
Objectives 19
Introduction 19
Definition 19
Derivation 19
Interpretation of IRP 25
Does IRP hold? 26
Applying IRP 26

iv WAWASAN OPEN UNIVERSITY
2.3 The theory of purchasing power parity 31
Objectives 31
Introduction 31
Definition 31
Derivation 32
Rationale behind PPP theory 35
Why PPP does not occur 35
PPP in the long run 36
Suggested answers to activity 39
2.4 The theory international Fisher effect 41
Objectives 41
Introduction 41
Derivation 41
Why IFE does not occur 43
Comparison of the PPP, IFP and IRP Theory 44
Summary of Unit 2 49
Suggested answers to self-tests 53

UNIT 2 1
Unit Overview
I n Unit 1 we looked at some basic concepts of international financial management

and exchange rate determinations. By now you should have a basic understanding
of exchange rates. This unit builds on Unit 1 material with additional discussion on
the theories of exchange rates.
There are three theories that explain exchange rate behaviour. Different theories
consider different factors that affect exchange rates. The first one is Interest Rate
Parity (IRP). IRP explains exchange rate changes by interest rate movements of
two countries. Purchasing power parity (PPP) is the second theory. It deals with
how price changes in two countries affect the exchange rate. The last theory is
the International Fisher Effect (IFE) which focuses on how inflation rates in two
countries may lead to changes in their interest rates. We shall discuss the three
theories one by one with derivations, numerical examples, and cases.
These three theories constitute the foundation of exchange rate behaviour. They
also help you to understand other materials in Units 3 to 5. IRP illustrates the
relationship between forward rate, spot rate, and interest rates in two countries and
the relationship that should exist due to arbitrage activities by market participants.
Therefore, forward rate is a convenient tool with which to hedge foreign exchange
rate risk (as discussed in Unit 3). The PPP and IFE explain how inflation rates
and interest rates in two countries affect the spot rate. As the PPP and IFE do
not always hold, decision-making by MNCs is very challenging. Thus, we need
to consider a lot of factors related to the short-term and long-term aspects of
multinational financial management (as discussed in Units 4 and 5).
Unit Objectives
By the end of Unit 2, you should be able to:
1. Explain the conditions that will result in various forms of international

arbitrage.
2. Explain the realignments that will occur in response to various forms of

international arbitrage.
3. Calculate the profit gained from various forms of international arbitrage.
4. Explain the concept of Interest Rate Parity (IRP), and how it prevents
arbitrage opportunities.
5. Explain the Purchasing Power Parity (PPP) theory, and its implications
for exchange rate changes.
2 WAWASAN OPEN UNIVERSITY
6. Explain the International Fisher Effect (IFE) theory, and its implications
7. Compare the PPP theory, the IFE theory, and the IRP theory.
UNIT 2 3
2.1 International Arbitrage and

Realignments
Objectives
By the end of this section, you should be able to:
1. Compare and contrast the various types of arbitrage.
2. Discuss the conditions that will result in various forms of international

arbitrage.
3. Critically analyse the realignments that will occur in response to various

forms of international arbitrage.
4. Calculate the profit gained from various forms of international arbitrage.
Introduction
Let us start by thinking about why we have to study the theories of exchange
rate determinations. A theory helps us to simplify real-world complex scenarios
so that we can develop a system of logical steps to analyse real-world issues.
For instance, once you understand how Interest Rate Parity works, you are able
to predict the direction of exchange rate changes when one country raises its
interest rate relative to the other country. Before we study the three theories of
exchange rate determination, we need to understand the meaning of international
arbitrage.
In this unit, you will learn the three theories of exchange rate determination.
First, you will comprehend the concept of international arbitrage discussed in this
section. Then, there will be a detailed discussion on the theories of Interest Rate
Parity (IRP), Purchasing Power Parity (PPP), and the International Fisher Effect
(IFE) in sections 2, 3 and 4. Finally, you will integrate all theories together in
section 5 and be able to draw implications on exchange rate movements.
The concept of arbitrage

This section introduces four different types of international arbitrage:
• Locational arbitrage
• Triangular arbitrage
• Covered and uncovered interest arbitrage

Arbitrage can be simply defined as taking a profit on a discrepancy in quoted

prices. Put it more simply, it is the act of buying an underpriced asset and selling
it at the higher parity price, under a riskless position.
If there is no profitable arbitrage in the market, the prices are said to be in arbitrage
equilibrium, and hence the market is arbitrage-free. The pre-condition to conduct
an arbitrage is that there must be a product mispricing in one of the markets,
as suggested by the law of one price (to be discussed in section 3 PPP) and the
product in the two markets must share the same quality. Arbitrage is not simply
buying low and selling high. Instead, the two transactions must be conducted
simultaneously to avoid any changes in market prices before both transactions
are complete.
The concept of arbitrage is basically a very simple market mechanism for price
determination and is a fundamental process for profit seeking. A person who
engages in arbitrage is called an arbitrageur, such as those who works for an
investment bank or brokerage firm. These type of arbitrageur focuses on trading in
financial instruments, including foreign currencies, stocks, bonds, and derivatives.
Of course, arbitrage is not content to only financial assets. In fact, the early
form of arbitrage activities was in commodities trading. Recently the activities in
arbitrage are getting sophisticated; there are merger arbitrages, municipal bond
arbitrage, depository receipts, dual-listed companies, regulatory arbitrage and
telecom arbitrage, see http://en.wikipedia.org/wiki/Arbitrage.
In the arbitrage process, no investment is needed and the risk assumed is nearly
zero. For instance, if stamp collection shop A is willing to buy a particular stamp
for $100 and stamp collection shop B is selling the same stamp for $90, then you
can buy the stamp from B and take the stamp to A to make $10 profit. If you
do that, you are doing arbitrage. Obviously, other people will carry out the same
activity as you until the price of the same stamp in both shops is the same. This
is the consequence of any violation of arbitrage conditions. Accordingly, there
would not be any arbitrage opportunity in an efficient market in the long run.
However, in the real world, financial markets are not perfectly efficient. Market
inefficiency may be due to incomplete information flow, institutional barriers,
or time lags of adjustments. Therefore arbitrage opportunities do exist. In this
section, we explore situations where arbitrage opportunities may arise.
Locational arbitrage
The above example is locational arbitrage since the discrepancy in prices occurs in
two different locations, or two different markets. Within the context of exchange
rate movement, locational arbitrage means capitalising on the differences in
exchange rates between locations. Let us consider the following example on different
quotations for Malaysian Ringgit (RM) over China renminbi Yuan (Y) in two of
the local Malaysian banks, i.e., Maybank and Public Bank:
UNIT 2 5
Public Bank Maybank

Bid Ask Bid Ask
China Yuan RM0.635/Y RM0.640/Y RM0.645/Y RM0.650/Y
exchange rate
Table 2.1 Foreign exchange quotation
First, we need to do a revision on bid and ask exchange rates. The example given
in Table 2.1 above is very close to the real world. A bid exchange rate is the
exchange rate when you sell China Yuan to a bank. An ask exchange rate is the
exchange rate when you buy China Yuan from the bank. For instance, if you
sell 1 Yuan to a Public Bank, Public Bank will give you RM0.635. Commission
is excluded. Similarly, if you would like to buy 1 Yuan from Public Bank, you
need to pay RM0.640.
Is there any locational arbitrage opportunity? The answer is ‘yes’. Consider the
following steps:
• You bring RM0.640 to buy 1 Yuan from Public Bank (use the Public Bank
ask exchange rate).
• You take 1 Yuan to Maybank and sell the 1 Yuan to get back RM0.645.
• Profit = RM0.645 − RM0.640 = RM0.005
Is the profit too small? Well, you need to think that the RM0.005 profit is
for every RM0.64 spent. If you used RM64 million, then the profit would be
RM500,000 or 0.78125%! Is 0.78125% a good return? Well, if you make the
return within 15 seconds and do not tie up funds, then the return is excellent.
Again, we assume the profit can cover the commission costs.
To illustrate the above case clearly, assuming an MNC in Malaysia has RM64
million to invest. Figure 2.1 shows exactly the case when there is a locational
arbitrage opportunity between the exchange rates of Malaysia Ringgit over
China Yuan. The MNC can convert the RM64 million into 10 million Yuan at
Public Bank at the ask price quoted in Public Bank at RM0.640/Y, and bring
this money to convert back to Ringgit at Maybank at the bid price quoted in
Maybank at RM0.645/Y and obtained RM64.5 million, a net of RM0.5 million.
This is a no-risk transaction given that the time frame involved is short  almost
simultaneously and thus no changes in the quoted bank rates between the two
transactions.
How do we identify if the quoted exchange rates of the two banks give rise
to locational arbitrage? From the above example, the key is to spot if the ask
exchange rate in one bank is less than the bid exchange rate in another bank. In
this case, the ask exchange rate at Public Bank is less than the bid exchange rate
at Maybank. Then we know that we can buy China Yuan from Public Bank and
resell them to Maybank. In the example, there is a spread in the asking price
of one bank and the bid price of the other bank on the same currencies. This
gives rise to a locational arbitrage opportunity. Is this possible in the real world?
The answer is ‘yes’. This is because banks quote bid/ask price based on their
knowledge as well as expectations about the market. As long as there are
differences in people’s knowledge and expectations, locational arbitrage
opportunity exists.
Start
RM64 million
Public Bank Maybank
RM0.64 million × RM0.640/Y × RM0.645/Y
= 10 million Yuan = RM64.5 million
The difference = RM64.5 million − RM64 million = RM0.5 million
Figure 2.1 Locational arbitrage
What will be the likely consequences? A lot of investors or institutions will do

exactly what we describe, i.e., buy China Yuan from Public Bank and resell them
to Maybank. How many arbitrage opportunities are there? How long will arbitrage
activity last?
The answers depend on a number of factors. First, information flow plays an

important role. Nowadays the speed of information flow is greatly enhanced
by technology. Electronic trading is a very good example. On the one hand, it
exposes more arbitrage opportunities because price information is shared by a lot
of parties. On the other hand, it shortens the duration of an arbitrage activity as
faster information flow enables people to realign prices faster.
Second, the faster people adjust their bid/ask prices, the shorter the arbitrage
activity will last. In the example, on the one hand, in response to a sudden
surge in demand for China Yuan, Public Bank will raise its ask exchange rate for
the China Yuan. Maybank, on the other hand, will lower its bid price for the
China Yuan in the light of a sudden big increase in the supply of China Yuan.
This price realignment by both parties will ultimately eliminate the arbitrage
opportunity when the ask exchange rates in both banks exceed the bid exchange
rates in another bank. In general, the faster the price realignment by parties in the
market, the shorter the arbitrage activity lasts.
Therefore, there will be realignment (changes) of the exchange rate between the
China Yuan and the dollar in both banks in a short period of time. The realignment
will stop after the ask exchange rates in both banks have exceeded the bid
exchange rates in the other banks.
UNIT 2 7
Activity 2.1
Answer the following questions.
Assume the following information:
Bank X Bank Y
Bid price of Swiss francs $0.961/SF $0.958/SF

Ask price of Swiss francs $0.964/SF $0.960/SF
Given this information, is locational arbitrage possible? If so,

explain the steps that would reflect locational arbitrage and
compute the profit from this arbitrage if you had $1,000,000 to
use.
Triangular arbitrage
Within the context of exchange rate movement, triangular arbitrage means
capitalising on discrepancies in cross exchange rates. Triangular arbitrage occurs
when a quoted cross exchange rate is not equal to the exchange rate that should
exist in equilibrium. Let us consider the following example:
Currencies Bid exchange rate Ask exchange rate
British pounds exchange $1.982/£ $1.983/£

rate in terms of dollars
Euro exchange rate in $1.5585/€ $1.5595/€
terms of dollars
British pounds exchange €1.2663/£ €1.2680/£
rate in terms of Euro
How do we identify the triangular arbitrage opportunity? The above triangular

arbitrage opportunity occurs because the cross exchange rate between the Euro
and the pound (i.e., €/£) is quoted as €1.2663/£ while the exchange rate (or the
equilibrium exchange rate) should be only €1.2724/£ (calculated as ($1.983/£
÷ $1.5585/€)). In this case, as the quoted rate (€1.2663/£) is smaller than the
equilibrium rate (€1.2724/£), we should try to use Euros to get pounds through
the exchange rate transactions. Hence, we sell dollars to get Euros, and sell Euros
to get pounds, and finally sell pounds to get back dollars. In brief, we need to
identify whether an equilibrium rate is different from the quoted rate through
various exchange rate calculations. If so, we can proceed to the transaction steps
outlined below.
Consider the following steps as illustrated in Figure 2.2:
Assume Mr. A borrow $10,000 from US bank.
• Convert $10,000 to Euros: $10,000 ÷ $1.5595/€ = €6,412.3116; note that

we use the ask exchange rate since the ask exchange rate is the rate for
customers to buy a foreign currency. In addition, it is useful to know that
the $ symbols are eliminated in the division.
• Convert €6,412.3116 to pounds × (1/1.2680) = £5057.03:
Note that we use the ask exchange rate since the ask exchange rate is the
rate for customers to buy a foreign currency. Again, it is useful to know that
the Euro symbols are eliminated in the multiplication.
• Convert £5,057.03 to dollars: $1.982/£ × £5,057.03 = $10,023.03; note

that we use the bid exchange rate since we are selling £, a foreign currency.
Also, the £ symbols are eliminated in the multiplication.
• Profit = $10,023.03 − $10,000 = $23.03;
• % profit = $23.03/$10,000 = 0.23%.
Start End
$10,000 ÷ $1.5595/€ Profit = $10,023.03 − $10,000
= €6,412.3116 = $23.03
€6,412.3116 ÷ €1.2680/£ £5,057.03 × $1.982/£

= £5,057.03 = $10,023.03
Figure 2.2 Triangular arbitrage
In the foreign exchange market, there are a lot of investors and institutions
looking for triangular arbitrage opportunities. If such opportunities exist,
investors and institutions only need a few phone calls or computer transactions
to complete the arbitrage. In addition, such arbitrage does not tie up funds.
Therefore, any such opportunities will be temporary as investors and institutions
will take advantage of the arbitrage and engage in the transactions outlined in
the example. The bid/ask exchange rate will change quickly so that the arbitrage
opportunities vanish within a short period of time.
UNIT 2 9
Reading
Please read the following article in WOU MyDigitalLibrary,

E-course reserves. This reading material is extracted from Madura
(2012) International Corporate Finance, 11th edn, South-Western
(pages 217 – 220).
After reading, please attempt the following activity.
Activity 2.2
Consider the following spot exchange rates:
Currencies Bid exchange rate Ask exchange rate
British pounds HK$15.3890/£ HK$15.5440/£

exchange rate in
terms of Hong Kong
dollars
Euro exchange rate HK$12.165/Euro HK$12.1955/Euro
in terms of Hong
Kong dollars
British pounds Euro1.266/£ Euro1.295/£
exchange rate in
terms of Euros
Is triangular arbitrage possible? If so, calculate the percentage of
profit/loss in terms of Hong Kong dollars.
Covered and uncovered interest arbitrage

Covered Interest Rate Arbitrage (CIA) is built on the violation of the theory of
interest rate parity (IRP) that will be discussed in the next section. Put simply,
CIA is based on the relationship between the forward rate premium or discount
(discussed in Unit 1) and the interest rate differential. The theory of IRP states
that the size of the premium or discount exhibited by the forward rate should be
about the same as the differential between the interest rates of the two countries
concerned. If the forward premium or discount deviates substantially from the
interest rate differential, covered interest arbitrage is possible. As a result, an
investor is able to make a good profit and not be exposed to fluctuations in the
foreign currency’s value.
Within the context of exchange rate movement, covered interest arbitrage means
capitalising on IRP discrepancies, i.e., between the forward rate and the interest
rate differential, without any exposure to currency risk. Covered interest arbitrage
involves investing in a foreign country to make a profit and at the same time
covering against exchange rate risk by a forward exchange rate contract, thus the
position is absolutely unexposed to currency risk.
To illustrate the concept, assume that you would like to take advantage of the
relatively high interest rates in Britain and you have funds available for 90 days.
The interest rate is fixed but there is uncertainty about the future spot exchange
rate between dollars and British pounds 90 days later. However, you can use the
forward exchange rate between dollars and pounds to eliminate the uncertainty of
the future spot exchange rate. The following are the relevant figures:
• You have $800,000 to invest.
• The current spot exchange rate is $1.97/£.
• The 90-day forward exchange rate is $1.945/£.
• The 90-day interest rate in Britain is 4%.
• The 90-day interest rate in the US is 2%.
The steps for making covered interest arbitrage are summarised below and illustrated
in Figure 2.3.
Step 1
• Convert dollars to pounds today: Amount of pounds received = $800,000 ÷

$1.97/£ = £406,091.
Step 2
• Deposit the £406,091 in a British bank at a 4% 90-day interest rate.

Expected principal plus interest = £406,091 × (1+4%) = £422,335.
• Simultaneously set up a 90-day forward contract to sell £422,335 at the

forward exchange rate of $1.945/£.
Step 3
• 90 days later, honour the forward contract and collect the dollars. Amount
of dollars received = £422,335 × $1.945/£ = $821,442.
This represents a 2.68% return (i.e., $21,442/$800,000 × 100%).

UNIT 2 11
It is noticed that the 2.68% return is higher than the local 2% return. Moreover,
the return can be locked in today since you would know at the moment you
make the deposit, exactly how much you will get back for the pounds you
accumulate.
How long will this arbitrage opportunity last? The answer is only for a very short
while. As with the other forms of arbitrage, market demand and supply forces
resulting from covered interest arbitrage will cause realignments. In the above
example, one or more of the four variables (UK interest rate, US interest rate, spot
rate, and forward rate) may change:
1. The UK interest rate will go lower, since there are more deposits in UK
banks.
2. The US interest rate will go higher, since the US banks need to raise rates
to attract more deposits.
3. The spot rate will go higher or the pound will appreciate in the spot
market, as demand for pounds increases.
4. The forward rate will go lower or the pound will depreciate in the 90-day
forward market, as the supply of pounds in the forward market increases.
Start US money market End

$800,000 × 1.02 $816,000
i$ = 2% per 90 days $821,442
= 8% per annum
90 days
Spot = $1.97/£ Forward = $1.945/£
London money market

£406,091 × 1.04 £422,335
£
i = 4% per 90 days
= 16% per annum
Figure 2.3 Covered interest rate arbitrage
Uncovered interest rate arbitrage (UIA) is a deviation from CIA. UIA is very
similar to CIA, except that the position is not covered by a forward contract and
hence exposed to currency risk.
To illustrate the case, let us use the same information as the above CIA case,
except that the interest rate in US money market now is only 0.5%. The
following are the relevant steps for making an uncovered interest arbitrage:
Step 1
• Convert dollars to pounds today: Amount of pounds received =

$800,000 ÷ $1.97/£ = £406,091.
Step 2
• Deposit the £406,091 in a British bank at a 4% 90-day interest rate.

Expected principal plus interest = £406,091 × (1 + 4%) = £422,335.
Step 3
• 90 days later, withdraw the pound principle plus interest rate of £422,335,
convert it at whatever spot rate quoted in the market (the future spot rates)
and collect the dollars. Assuming spot rate at the maturity date is only
$1.92, the amount of dollars received = £422,335 × $1.92/£ = $810,883.
This represents a 1.36% return (i.e., $10,883/$800,000 × 100%).
The above steps are illustrated in Figure 2.4, which is very similar to Figure 2.3
except that there is no forward rate at the right hand side; it is replaced by the
spot rate at the maturity date, the so-called future spot rate.
In the above example, the arbitrageur was lucky enough that the spot rate at
the maturity is $1.92/£, such that he or she still managed to get a higher return
than the opportunity investment in US money market. However, the action is
essentially uncovered and exposed to lower spot rate and hence lower profit.
Note that as long as the rate is above $1.8943/£, there will be a net positive profit
from the investment in London money market, i.e., the net converted dollar
amount is higher than $800,000. However, to beat the net amount of $804,000
from investing in US money market, the future spot rate must not be at any
value lower than $1.9037/£.
It is noticed that the 2.68% return is higher than the local 2% return. Moreover,
the return can be locked in today since you would know at the moment you
make the deposit, exactly how much you will get back for the pounds you
accumulate.
Why arbitrageurs want to risk themselves through UIA when they are able to
hedge their currency risk with CIA? Is there any applicability of UIA in real
cases? The answer is yes. There is an age-old application of UIA in the “yen carry
trade”. This is the case where investors in Japan, both local and foreign, take
advantage of extremely low interest rates in Japanese yen, of about 0.4% per
annum, to raise cheap capital locally, and convert the capital into other currencies
like US dollar or Euros, and reinvest these foreign currencies in dollar or Euro
money markets to get higher returns, say 5% per annum. At the maturity, they
UNIT 2 13
convert the dollar or Euro proceeds back into Japanese yen in the spot market,
still yielding a tidy profit after repaying the cheap loan they raised in the local
market.

$800,000 × 1.005 $804,000
i$ = 0.5% per 90 days $810,883
= 2% per annum
90 days
Spot = $1.97/£ SpotF = $1.92/£
London money market

£406,091 × 1.04 £422,335
i£ = 4% per 90 days
= 16% per annum
Figure 2.4 Uncovered interest rate arbitrage
Reading

(pages 222 – 226).
After reading, please attempt the following activity.
Activity 2.3
The one-year Swiss interest rate is 6%. The one-year US

interest rate is 10%. The spot rate of the Swiss franc is $0.90/
SF. The forward rate of the Swiss franc is $0.94/SF. Is covered
interest arbitrage feasible for US investors? Is it feasible for Swiss
investors? Explain why each of these opportunities for covered
interest arbitrage is or is not feasible.
Activity 2.4
XYZ is a Hong Kong-based MNC that is expanding its business

in Eastern Europe. One of the Eastern Bloc countries has allowed
its currency’s value to be market-determined. The spot rate for
this currency is HK$0.80/E (where E is the unit of this Eastern
European country). In order to attract foreign investments, this
Eastern Bloc country allows investments by foreign investors.
Currently, its one-year government bond is offering 15% yield,
which is substantially higher than the 8% one-year certificate of
deposit (CD) offered by any Hong Kong bank.
A local bank in this Eastern European country begins to create a

forward market for the currency of the country. This local bank
has quoted a one-year forward rate of HK$0.78/E.
As the chief financial officer of XYZ, you have been asked to

assess the possibility of investing short-term funds in this Eastern
European country. You are in charge of investing HK$50 million
over the next year. Your objective is to earn the highest return
possible while maintaining virtually no default risk.
Since the exchange rate has just become market-determined,

it is expected that the currency (E) will be very volatile. After
consulting several experts, you believe that the expected spot rate
of E in one year is HK$0.80/E. However, the actual value of the
spot rate may be 30% above or below HK$0.80/E.
Questions
1. Would you be willing to invest the HK$50 million in this

country without covering your position? Why/Why not?
Give a brief explanation of your reasons.
2. If you decide to use covered interest arbitrage, what is your

expected return from your investment of the HK$50 million?
3. Even if you decide to use covered interest arbitrage, what

additional risks are involved in investing in this Eastern
European country?
UNIT 2 15
Summary
1. Arbitrage can be simply defined as taking a profit on a

discrepancy in quoted prices.
2. Locational arbitrage means capitalising on the differences in

exchange rates between locations.
3. Triangular arbitrage means capitalising on discrepancies in

cross exchange rates.
4. Covered Interest Rate Arbitrage (CIA) is built on the

violation of the theory of interest rate parity (IRP).
5. CIA is based on the relationship between the forward rate

premium or discount (discussed in Unit 1) and the interest
rate differential.
6. UIA is very similar to CIA, except that the position is not

covered by a forward contract and hence exposed to currency
risk. A good example is the yen carry trade.
Self-test 2.1
1. As a foreign exchange dealer at a medium-sized local bank in

Hong Kong, you have been given the following information
early in the morning:
Spot rate of British pounds HK$15.38/£

Spot rate of Australian dollar HK$7.47/A$
Cross exchange rate A$2.06/£
One year forward rate for Australian dollar HK$7.20/A$
One year forward rate for British pound HK$15.40/£
One year Hong Kong interest rate 8%
One year British interest rate 9%
One year Australian interest rate 7%
Determine if triangular arbitrage is feasible. If so, how would

it be conducted to make a profit?
2. Using the information above, determine whether covered

interest arbitrage is feasible for the Hong Kong dollar and the
British pound.
Suggested answers to activities
Feedback
Activity 2.1
Yes! One could purchase Swiss francs at Bank Y for $0.96/SF

and sell them to Bank X for $0.961/SF. With $1m available,
1.0417m Swiss francs could be purchased at Bank Y. These Swiss
francs could then be sold to Bank X for $1,041,700 thereby
generating a profit of $1,041.60.
Activity 2.2
• Convert HK$10,000 to pounds: HK$10,000 ÷ HK$15.544/£

= £643.34.
• Convert £643.34 to Euros: Euro1.266/£ × £643.34 =
Euro814.
• Convert Euro814 to Hong Kong dollars: HK$12.165/Euros ×

Euro814 = HK$9,902.
• Profit = HK$9,902 − HK$10,000 = −$98.
• % loss = $98/$10,000 = 0.98%.
Activity 2.3
• To determine the yield from covered interest arbitrage by

US investors, start with an assumed initial investment, such
as $1,000,000.
• Convert $1,000,000 to Swiss francs today: amount of SF

received = $1,000,000 ÷ $0.9/SF = SF1,111,111
• Deposit the SF1,111,111 into a Swiss bank and earn 6%

interest.
UNIT 2 17
• Principal plus interest = SF1,111,111 × (1.06) = SF1,177,778
• Use forward contract to convert SF2,120,000 back to $,

amount = SF1,177,778 × $0.94/SF = $1,107,111
• % yield = 10.7190% which is higher than the US interest

rate of 10%
• Hence, US investors can benefit.
• Similarly, to determine the yield from covered interest

arbitrage by Swiss investors, start with an assumed initial
investment, such as SF1,000,000.
• Convert SF1,000,000 to dollars today: amount of $ received

= SF1,000,000 × $0.90/SF = $900,000.
• Deposit $900,000 into a US bank and earn 10% interest.
• Principal plus interest = $900,000 × (1 + 10%) = $990,000.
• Use forward contract to convert $990,000 back to SF:

amount = $990,000 ÷ $0.94/SF = SF1,053,191.
• % yield 5.32% which is lower than the Swiss interest rate of

6%.
• Therefore, Swiss investors would not benefit.
Activity 2.4
1. No. The HK$50 million is a short-term fund and it should

be put in safe investment. Without covering the company’s
investment in the foreign country, the future spot rate may
be 30% below the current spot rate. If this occurs, the loss
will be huge. The following is the worst case scenario:
HK$50m ÷ HK$0.80/E × (1 + 15%) × HK$0.80/E × (1 − 30%)
= HK$40.25m which is a loss of HK$9.75m.
2. Expected return: (1) principal plus interest after one-year =

HK$50m ÷ HK$0.80/E × (1 + 15%) × HK$0.78/E =
HK$56.0625m; (2) expected return = (HK$56.0625 −
HK$50)/HK$50 = 12.125%. It is higher than the expected
return from depositing the money in a Hong Kong bank.
3. Political risk and default risk. The Eastern European country

may be politically unstable and the local government may
change its policy such that it is difficult to convert its
currency back to foreign currencies. In addition, the bank
that offers the deposit may default. There is no mention of
deposit insurance.
UNIT 2 19
2.2 The Theory of Interest Rate Parity

Objectives
1. Compute forward rate premium and discount.
2. Critically discuss Interest Rate Parity (IRP).
3. Apply the principles of IRP to detect arbitrage opportunity.
4. Analyse the dynamic adjustment in the spot, forward foreign exchange

market and interest rate whenever there is an arbitrage opportunity.
Introduction
This section introduces the theory of Interest Rate Parity (IRP). Following the
covered interest arbitrage introduced in the last section, once market forces cause
the interest rates and exchange rates to be such that covered interest arbitrage
is no longer feasible, the equilibrium state is referred to as Interest Rate Parity
(IRP). In this part of the unit, you will study an analytical derivation of IRP, a
numerical example, and a case on IRP.
Definition
The theory of IRP basically tries to explain the relationship between the foreign
exchange forward markets and the international money markets. The IRP
is defined as: the difference in the interest rates for assets of similar risk and
maturity in two markets should be equal to the forward discount or forward
premium for the exchange rate of the two national currencies, but opposite in
direction, assuming there is no transportation cost.
Derivation
I would like to introduce an approach to derive IRP. This approach is practical.
There are more than one approach in the derivation of IRP. The approach suggested
in the following section is practical and is easier to relate to daily operations in the
finance profession. I start with a numerical example and then use some mathematical
symbols to derive IRP.
Let us consider the following covered interest arbitrage. This example is similar to
the one in the previous section with slightly different scenarios. You are given the
following information:
• Spot rate: $2.00/£
• 90-day forward exchange rate: $2.01/£
• US 90 day interest rate: 2%
• UK 90 day interest rate: 4%
Let us assume that bid/ask spread is not economically significant; that is, the
cost of the transaction that involves the spread is not critical to the transaction.
Even better, let’s further assume that we can borrow $1,000,000 at the current
interest rate, so we don’t have to use our own funds in this transaction. In other
words, this is a zero cost investment. We can use the following steps to obtain an
arbitrage profit.
Step 1
• Borrow $1,000,000 in the US at 2% and convert the $1,000,000 to pounds.
• Amount of pounds received = $1,000,000/($2.0/£) = £500,000.
Step 2
Invest £500,000 for 90 days in the UK at 4%.
• Principal and interest received to be received 90 days later = £500,000 ×

(1 + 4%) = £520,000.
• Lock in a 90-day forward contract to sell £520,000 at $2.01/£.
Step 3
• Honour the forward contract.
• Dollars received = £520,000 × ($2.01/£) = $1,045,200
Step 4
• Repay the loan; how much?
• $1,000,000 × (1 + 2%) = $1,020,000
• Covered interest arbitrage profit = $1,045,200 − $1,020,000 = $25,200.

UNIT 2 21
This represents a 2.52% return (i.e., $25,200/$1,000,000 × 100%).
The above steps are illustrated in Figure 2.5, which is the same as Figure 2.3,
except for the numbers.
What will happen next? As we have argued in the previous section, everyone executes
this type of trade until the spot rate, forward rate, and interest rates in the US and
the UK change such that no further covered interest arbitrage exists.

$1,000,000 × 1.02 $1,020,000
i$ = 2% per 90 days $1,045,200
= 8% per annum
90 days
Spot = $2.00/£ Forward = $2.01/£
London money market

£500,000 × 1.04 £520,000
£
i = 4% per 90 days
= 16% per annum
Figure 2.5 Covered interest rate arbitrage for IRP
Let us use the following symbols to examine the steps one by one. It will help us
to derive the equilibrium condition which IRP holds and to identify if there exist
any arbitrage opportunities.
• S = spot exchange rate (i.e., $2.00/£ in the example)
• F = forward exchange rate (i.e., $2.01/£ in the example)
• if = interest rate in foreign country (i.e., 4% in UK in the example)
• ih = interest rate in home country (i.e., 2% in US in the example)
The following steps correspond to the steps outlined. We use $1 instead of

$1,000,000. Or you can use all the numbers and divide them by 1,000,000.
Step 1
• Borrow $1 in US at ih and convert the $1 to pounds at the spot exchange

rate.
• Amount of pounds received = $1/($S/£) = £(1/S ).
Step 2
• Invest £(1/S) for 90 days in UK at if .
• Principal and interest to be received 90 days later = £(1/S ) × (1 + if ).
• Lock in a 90-day forward contract to sell [£(1/S ) × (1 + if )] at forward

rate F.
Step 3
• Honour the forward contract.
• Dollars received = $(1/S ) × (1 + if ) × F.
Step 4
• Repay the loan; how much?
• $1 × (1 + ih).
• Covered interest arbitrage profit = $(1/S ) × (1 + if ) × F − $1 × (1 + ih).
If there is no covered interest arbitrage, then the covered interest arbitrage profit
will be zero. So we can set:
(1/S ) × (1 + if ) × F − 1 × (1 + ih) = 0
or
F (1 + ih)
= (1)
S (1 + if )
UNIT 2 23
If we minus 1 on both sides,

F (1 + ih)
−1= −1
S (1 + if )
F−S (1 + ih) − (1 + if ) (i − i )
= = h f (2)
S (1 + if ) (1 + if )
A lot of the time, the forward and spot exchange rates refer to a particular time.
Therefore, equation (2) can also be expressed as:
Ft − St (i − i )
= h f (2a)
St (1 + if )
The above relationship exhibited in equations (1) and/or (2) is called Interest
Rate Parity (IRP). You should be aware that the left-hand side in equation (2)
is forward premium (or discount) and the right-hand side is (ih − if )/(1 + if ).
If (1 + i f ) is very small (for a country with a low interest rate), then we
can approximate (1 + if ) as 1. Then we have forward premium or discount
approximately equal to interest rate differential in the two countries. We have the
following:
F−S
= forward premium (or discount) ≅ (ih − if ) (3)
S
However, you need to be careful with the interest rate representation. For instance,
when he says the 3-month interest rate is 2%, you should think about that as an
annual interest rate of 8% (i.e., 2% × 4). In reality, the interest rates quoted by banks
are annualised interest rates. If the quoted interest rates are annualised rates, we
need to use annualised forward premium or discount in the IRP.
Let us examine the example at the beginning of this section using equation (2a).
The (Ft − St )/St = (2.01 − 2.00)/2.00 = 0.005 is greater than (ih − if )/(1 + if ) =
(2% − 4%)/(1 + 4%) = −0.01923. In this case, the forward rate is too high and/
or the spot rate is too low relative to interest rate differentials. Therefore, we
sell dollars and buy pounds in the spot market (step 1) and buy dollars and sell
pounds in the forward market (step 2). Please also be aware that this logic also
applies to the covered interest arbitrage example in the previous section and in the
following numerical examples.
Numerical examples
1. Let us use some numbers you are familiar with. Consider the following
information:
• The 6-month interest rate in Hong Kong is 5% (i.e., 5% is for six

months’ holding or 10% for a year).
• The 6-month interest rate in mainland China is 6% (i.e., 6% is for six

months’ holding or 12% for a year).
• The spot exchange rate between renminbi (or yuan) and Hong Kong
dollars is HK$1.10/Y where Y is the symbol for renminbi.
If a bank is asked to provide a 6-month forward exchange rate contract

for a preferred customer, what should be the quoted forward rate?
Answer
In this case, Hong Kong is the home country and mainland China is
the foreign country. The spot exchange rate is a direct quotation, i.e., in
HK$/Y or home country currency per unit of foreign currency. There are
a lot of investors and institutions buying and selling renminbi in Hong
Kong. You would expect the IRP to hold. Use the IRP equation expressed
in (1):
F (1 + ih)
=
S (1 + if )
(1 + ih)
F=S×
(1 + if )
F = (HK$1.1/Y) × 1.05/1.06
= HK$1.0896/Y
Therefore, the bank should quote HK$1.0896 per renminbi for the
6-month forward exchange rate contract. If for some reason the interest
rate in Hong Kong goes up, then the (1 + ih) in the numerator of the
equation becomes bigger and the forward rate should become smaller and
vice versa.
2. Assume that the Japanese yen’s forward premium is 6% for a 12-month

forward exchange rate contract with respect to US dollars and that
Interest Rate Parity exists. How will this forward premium change if US
interest rates decrease, in order for Interest Rate Parity to be maintained?
UNIT 2 25
Answer
Since we do not have the exact spot and forward exchange rate, we need
to use IRP equation (3). US is the home country and Japan is the foreign
country.
forward premium (or discount) × (ius − ijap)

6% × (ius − ijap)
If the interest rate in the US decreases, i.e., ius becomes smaller, (ius − ijap)
would also become smaller. For IRP to exist, the forward premium must
be smaller.
Activity 2.5
Assume the following information between Canadian dollar and

US dollar:
• The 30-day forward premium of the Canadian dollar was

−1% relative to the US dollar (annualised).
• The 90-day forward premium of the Canadian dollar was 2%

(annualised).
Explain the likely interest rate conditions in the US and Canada

that would cause these conditions.
Interpretation of IRP
IRP is sometimes mistakenly interpreted as follows: ‘If IRP exists, then foreign
investors will earn the same returns as the local investors.’ This statement is
incorrect. Consider the above example between Hong Kong and mainland China
and assume the 6-month forward exchange rate is really HK$1.0896/Y and IRP
holds. Hong Kong investors could achieve a 5% return in six months domestically
or attempt covered interest arbitrage. Mainland China investors could achieve
a 6% return in six months or attempt covered interest arbitrage. Thus, Hong
Kong and mainland China investors do not have the same returns in six months.
Therefore, the correct way to interpret IRP is that if IRP exists, investors cannot
use covered interest arbitrage to achieve higher returns than those achievable in
their respective home countries.
Does IRP hold?

IRP holds quite well in the real world. Empirical research on the IRP theory
usually supports the theory even though we may have market imperfections such
as tax or bid-ask spread.
Another reason IRP holds quite well is that foreign exchange dealers use IRP
theory in guiding their operations. For instance, they use IRP to examine if
forward and/or spot exchange rates are ‘out-of-line’ with respect to interest rates
in the home and foreign countries. If IRP does not hold, the foreign exchange
dealers will execute covered interest arbitrage as described at the beginning of this
section. The arbitrage activities among all the foreign exchange dealers around
the world will make IRP hold. In addition, when a major bank’s foreign exchange
department is asked to quote a forward rate by its customers or other smaller
banks, the major bank will quote a forward rate based on the calculations from
equation (1) plus the necessary bid or ask spread. Therefore, the IRP theory
described in equation (1) is likely to be observed in the real world.
Applying IRP
The following are several applications of IRP:
• Foreign exchange dealers use IRP to set up forward exchange rates (as
illustrated in the Numerical examples section of IRP).
• Investors and institutions use IRP to calculate the percentage return of

their investment if they use covered interest arbitrage (as illustrated in the
Covered Interest Arbitrage Section).
• Businesses can use IRP to judge if they have a reasonable quotation of the
forward exchange rate (as illustrated in the following activity).
Reading

(pages 230 – 234).
UNIT 2 27
Activity 2.6
The Chinese Food Exports Company exports authentic dried

and canned Chinese food to the United Kingdom. The company
receives British pounds for its sales every month. John Lee, the
owner, just received a cheque (denominated in pounds) from
his major customer. John Lee normally deposits the cheque in a
small bank near his office in Kwai Chung and requests the bank
to convert the cheque to Hong Kong dollars at the prevailing
spot exchange rate. John’s bank, because of its small size, does
not provide many foreign exchange services for its customers.
This time, John decides to check the quotations of the spot rate
among other banks before converting the cheque into Hong Kong
dollars.
Questions
1. Do you think John will be able to find another bank that

provides him with a more favourable spot rate than his bank?
2. John is considering the use of a forward contract to have a

sure Hong Kong dollar amount of future accounts receivable
in pounds next month. His bank quoted him a spot rate of
HK$12/£ and a one-month forward rate of HK$11.5/£.
Before John decides to sell pounds one month forward, he
wants to be sure that the forward rate is reasonable, given the
prevailing spot rate. A one-month government bond in the
UK currently offers a yield of 0.75% (not annualised) while
a one-month government bond in Hong Kong currently offers
a yield of 0.60%. Do you believe that the one-month forward
rate is reasonable given the spot rate of HK$12/£?
Summary
1. The IRP is defined as: the difference in the interest rates for
assets of similar risk and maturity in two markets should be
equal to the forward discount or forward premium for the
exchange rate of the two national currencies, but opposite in
direction, assuming there is no transportation cost.
F−S (1 + ih) − (1 + if ) (i − i )
2. = = h f . You should be aware
S (1 + if ) (1 + if )
that the left-hand side in this equation is forward premium (or
discount) and the right-hand side is (ih − if )/(1 + if ). If (1 + if )
is very small (for a country with a low interest rate), then we
can approximate (1 + if ) as 1.
3. Then we have forward premium or discount approximately

equal to interest rate differential in the two countries. We have
the following:
F−S
= forward premium (or discount) ≅ (ih − if )
S
Self-test 2.2
1. Assume the following information:
Quoted price
Spot rate of Canadian dollar $.80

90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%
Given this information, what would be the yield (percentage

return) to a U.S. investor who used covered interest arbitrage?
(Assume the investor invests $1,000,000.) What market forces
would occur to eliminate any further possibilities of covered
interest arbitrage?
UNIT 2 29
2. If the relationship that is specified by interest rate parity does

not exist at any period but does exist on average, then covered
interest arbitrage should not be considered by U.S. firms. Do
you agree or disagree with this statement? Explain.
3. Assume that the Japanese yen’s forward rate currently exhibits

a premium of 6 percent and that interest rate parity exists. If
U.S. interest rates decrease, how must this premium change
to maintain interest rate parity? Why might we expect the
premium to change?
Feedback
Activity 2.5
The scenario would occur when the Canadian 30-day interest rate
is above the US 30-day interest rate, but the Canadian 90-day
interest rate is below the US 90-day interest rate.
Activity 2.6
1. Yes. A larger bank with a bigger foreign exchange operation

could be more competitive.
2. According to IRP, the 1-month forward rate should be =

S × (1 + ih)/(1 + if ) = HK$12/£ × (1 + 0.60%)/(1 + 0.75%) =
HK$11.98/£. The forward rate offered by the bank is too
low.
UNIT 2 31
2.3 The Theory of Purchasing Power

Parity
Objectives
1. Discuss the Purchasing Power Parity (PPP) theory, and its implications
on exchange rate changes.
2. Analyse the impact of inflation differential between two countries on the

exchange rate.
3. Critically analyse whether PPP holds in the long run.
4. Compute expected exchange rate according to the principles of PPP.
Introduction
In Unit 1, we discussed how inflation rates in two countries can have a strong
impact on exchange rates. This section introduces the Purchasing Power Parity
(PPP) theory and its implications for exchange rate changes. We will examine the
details behind the reasons why inflation rates in two countries are the important
factors in determining exchange rate changes.
Definition
The theory of PPP serves to explain the relationship between the foreign exchange
markets and the goods and services markets. The PPP (absolute version) is
defined as: the difference in the prices for goods and services of similar quality in
two markets should be equal to the exchange rate of the two national currencies,
assuming there are no barriers in mobility of the goods and services, and also no
transportation cost.
Essentially, what PPP is trying to say is given the principle of competitive market,
prices should equalise across markets, requiring only a conversion from one
currency to the other. Why must this be so?
Derivation
Before we discuss the PPP theory, we need to discuss an economic concept
called the law of one price (LOP). LOP is one of the most powerful laws in
international finance. LOP states that any goods will cost the same whether
purchased directly with one currency (say, currency A) or whether a currency (A)
is first converted to another currency (say, currency B) at the going exchange rate
and then used to purchase the same goods.
In mathematical symbols, we have:
Ph, t = St(Pf, t) (4)
where
Ph, t = domestic price at time t
St = exchange rate at time t (in domestic/one unit of foreign currency)
Pf, t = foreign price at time t
Different currencies represent purchasing power over goods and services. The
exchange rate between the two countries adjusts to keep purchasing power
constant. This adjustment will occur through commodity arbitrage. The concept
above is called absolute Purchasing Power Parity or sometimes absolute PPP.
Equation (4) is a representation of absolute PPP.
Consider the following commodity arbitrage example. Gold in New York is

trading for $400 per ounce, while in London it is trading for £250 per ounce.
Then the law of one price (LOP) implies:
$400 = St(£250)
St = $1.60/£
If the exchange rate is $1.50/£, then we can buy one ounce of gold at £250
in London and ship the ounce of gold to New York. In New York, we can sell
the ounce of gold for $400 and convert to pounds at $1.50/£. We can receive
£266.67 (i.e., $400 ÷ $1.50/£). The profit is £16.67 (i.e., £266.67 − £250).
The above example of LOP has several assumptions. They are:
1. no transaction cost
2. no barriers to trade
3. homogeneous goods.
UNIT 2 33
In practice, there are transaction costs to buy or sell gold in different locations.
For example, there will be a substantial cost to rent a ship to move the gold
from London to New York. There are barriers to trade. A lot of the time, the US
Government may not allow you to import a large amount of gold from the UK.
Finally, we may come across situations where goods in both countries may not be
of the same quality. For instance, the degree of purity of gold in London may be
different from that of the gold in the US. If any of these scenarios occur, it would
be difficult for the PPP theory to hold.
PPP does not hold very well because it requires the price of all goods in both
countries to be the same. We also understand that this is a very difficult condition
to meet. Since absolute PPP does not hold very well, some financial economists
develop another version of PPP with relaxed assumption. It is called relative
Purchasing Power Parity or relative PPP. Relative PPP requires the use of
price indices and price changes in both countries, not the price of every item in
two countries. According to relative PPP, we consider only price indices in both
countries. Relative PPP involves looking at the PPP theory with price index
ratios.
Ph, t + 1 S P
= t + 1 × f, t + 1
Ph, t St Pf, t
or
St + 1 P /P
= h, t + 1 h, t (5)
St Pf, t + 1/Pf, t
where
Ph, t = domestic price index at time t
St = exchange rate at time t (in domestic/one unit of foreign currency)
Pf, t = foreign price index at time t
Ph, t + 1 = domestic price index at time t + 1
St + 1 = exchange rate at time t + 1 (in domestic/one unit of foreign currency)
Pf, t + 1 = foreign price index at time t + 1
or
1 + Ih
St + 1 = St × (6)
1 + If
where
1 + Ih = (Ph, t + 1/Ph, t) = 1 + inflation rate in the home country
1 + If = (Pf, t + 1/Pf, t) = 1 + inflation rate in the foreign country

Equation (6) can be rearranged as:

St + 1 1 + Ih
=
St 1 + If
St + 1 1 + Ih
⇒ −1= −1
St 1 + If
St + 1 − St (1 + Ih) − (1 + If)
⇒ = ≅ Ih − If if If is very small (7)
St 1 + If
Both equations (5) and (6) are representations of relative PPP. Equation (7) is an
approximation of relative PPP. The left-hand side of equation (7) is the percentage
change in exchange rate or appreciation/depreciation percentage over a period of
time. The right-hand side of equation (7) is approximately equal to the inflation
rate differences in both countries. Practically, relative PPP is less restrictive than
absolute PPP. Absolute PPP requires the law of one price to hold for every item.
On the other hand, relative PPP only requires the percentage change in exchange
rates to be equal to the ratio of the percentage change in the home price level to
the percentage change in the foreign price level.
Numerical examples
Let us have one example of absolute PPP and one example of relative PPP before
the issue of the Euro.
• Absolute PPP: Ph, t = St(Pf, t)
Example: Suppose the average price of a ‘typical’ item in the US is $3,000.

That is, Ph, t = $3,000. At the same time, the average price of the same
‘typical’ item in France is FF24,000. Pf, t = FF24,000. Then, according to
absolute PPP,
$3,000 = St(FF24,000)
or the exchange rate, St = $0.125/FF
Obviously, LOP has to hold for the same item in both the US and France.
• Relative PPP: [St + 1/St] = [Ph, t + 1/Ph, t]/[(Pf, t + 1)/(Pf, t)]
Example: In December 1978, the exchange rate of German marks was

$0.53217/DM and the US consumer price index (CPI) level was 195.4
while the German CPI was 160.2. In December 1979, the US CPI was
217.4 while the German CPI was 166.6. The observed exchange rate in
December 1979 was $0.57671/DM.
UNIT 2 35
According to relative PPP (use equation (5), the exchange rate in December
1979 = $0.56934/DM
which was slightly different from the observed $0.57671/DM in December

1979. Nevertheless, the relative PPP predicts that the $/DM exchange rate
was higher, which indicates that the German mark appreciated. The relative
PPP theory predicts the exchange rate changes in the correct direction. This
suggests that while PPP is a relevant theory, it should be emphasised that
PPP will not always hold ‘perfectly’. It does, however, provide a foundation
for us to understand how inflation rates affect exchange rates.
Rationale behind PPP theory

If two countries produce substitutes for each other, the demand for products
should adjust as inflation rates differ. To illustrate this, let us assume the inflation
rate in Malaysia is 10% while the inflation rate in Singapore is 5%. This should
initially cause Malaysia consumers to increase imports from Singapore and
Singapore consumers to lower their demand for Malaysian goods (since the prices
of Malaysia goods have increased by a lower rate). Such forces place upward
pressure on the Singapore dollar and downward pressure on the Malaysia Ringgit
in the foreign exchange market.
The shifting in consumption from Malaysia to Singapore goods continues until

the Singapore dollar value has appreciated relative to Malaysia Ringgit to the
extent that: (1) the prices paid for Singaporean goods by Malaysian consumers
is no longer lower than the prices for the comparable goods made in Malaysia;
and (2) the prices paid for Malaysian goods by Singaporean consumers are no
longer higher than the prices for the comparable products made in Malaysia. As
predicted by the relative PPP theory (equation (7), the level of appreciation of the
Singapore dollar needed to achieve this is approximately 5%.
Why PPP does not occur

PPP does not consistently occur. The following are several reasons:
• There are other influential factors. Exchange rates are also affected by other
factors. Recall from Unit 1 that interest rates, income levels and government
controls are also important.
• There are trade barriers such as tariffs and import quotas. These trade barriers
hinder the commodity flows, which are important adjustment factors.
An article by Norrbin and Chan (1991), provides major reasons why PPP does
not hold. They find that exchange control (a form of government control),
the inflation rate (PPP underlying force), trade concentration (a form of trade
barrier) and monetary shocks (government policy that relates to inflation) are
significant factors that explain why PPP does not hold. Please read the article.
Reading
Norrbin, S C and Chan, K C (1991) ‘Causes of deviations from

purchasing power parity across countries’, Journal of International
Financial Markets, Institutions & Money, 1(4): 29 – 43.
The findings from the article suggest that inflation is the major factor. Therefore,
PPP is particularly useful for predicting exchange rate changes for a country with a
huge inflation rate. That is, if you need to predict the future expected appreciation
or depreciation of a currency for a high inflation country, PPP would be very useful.
PPP in the long run

PPP in the short run does not hold very well. The short run refers to about
three years’ time. Over the long run (for more than three years), PPP explains
the changes in exchange rate better. When Hong Kong pegged its exchange rate
to the US dollar in the early 1980s, the rate was set at US$1 = HK$7.8. This
HK$7.8/$ was set based on the long-term inflation rates in the US and Hong
Kong. In effect, the Hong Kong Government used a long-run PPP relationship to
establish the ‘equilibrium’ exchange rate between the Hong Kong dollar and the
US dollar.
The following reading provides a more detailed elaboration of our discussion of

PPP theory. You will learn more by reading the material and relating it to the
discussion on PPP theory here.
Reading
‘The Big Mac index’, The Economist, July 5 2007.
A lot of organisations, including governments and banks, have

spent a lot of resources paying researchers and economists to
determine the value of various currencies in different countries
and exchange rates. What The Economist has suggested in humour
is that one need not spend this money. All one really needs to do
is determine the cost of a Big Mac in various countries. The Big
Mac index has been prepared by The Economist magazine since
1986. The magazine has tracked the price of the Big Mac around
the world. The theory of PPP is applied to the current price of
Big Macs in different countries around the world to determine
the extent to which currencies are over- or under-valued. It
is argued that, in the long run, the exchange rate between
two countries should move towards the rate that equalises the
prices of an identical basket of a McDonald’s Big Mac in each
UNIT 2 37
country. Thus, as mentioned in the article, the Big Mac PPP is

the exchange rate that would mean hamburgers cost the same in
America as abroad.
Note: You can go to www.economist.com to get the latest Big Mac

index.
Now, after reading the article, it is time for you to do the following
activity before we start the next topic.
Activity 2.7
Impact of Russian inflation on exchange rates
The opening of Russia’s market in the early and mid-1990s has

encouraged many multinational corporations to expand their
business in Russia. However, the expansion into Russia has resulted
in numerous problems for MNCs such as McDonalds and IBM,
among others.
Specifically, the value of the Russian currency (the ruble) has

been very volatile from 1990 – 98. In fact, it can decline by 15%
on a single day. One of the main reasons for persistent weakness
in the ruble is Russia’s inflation. On average, the inflation rate in
Russia has commonly exceeded 20% per month. Russian interest
rates commonly exceed 150%, but this is far less than the annual
inflation rate in Russia, which is estimated to be 800% per year
over the period.
Source: Madura, 5th edition, page 253.
Questions
1. Explain why the Russian inflation of about 800% was placing

severe pressure on the value of the Russian ruble.
2. Does the effect of Russian inflation on the decline of the

ruble’s value support the theory of Purchasing Power Parity
(PPP)? How might the relationship be distorted by political
conditions in Russia?
Summary
1. Basically the theory of PPP tries to relate prices in goods

and services markets to the currency exchange rates between
two countries.
2. The absolute PPP discusses the connection between price level

and exchange rate in level, while the relative PPP focuses on
the changes of the price level and changes in the exchange
rates.
3. The assumptions require that the qualities of the products

across the markets must be homogeneous, no barriers in
mobility and zero transportation cost. Given this restrictive
assumption, logically PPP is not likely to hold in the short
run. In the long run, empirical studies find that PPP performs
fairly better.
Self-test 2.3
1. Explain the theory of purchasing power parity (PPP). Based

on this theory, what is the general forecast of the values of
currencies in countries with high inflation?
2. Explain how you could determine whether PPP exists.

Describe a limitation in testing whether PPP holds.
3. Assume that the spot exchange rate of the British pound is

$1.73. How will this spot rate adjust according to PPP if the
United Kingdom experiences an inflation rate of 7 percent
while the United States experiences an inflation rate of 2
percent?
UNIT 2 39
Suggested answers to activity
Feedback
Activity 2.7
1. According to relative PPP, if Russia has an 800% inflation rate

(i.e., If), the future spot rate (St + 1) would be much smaller
than the current spot rate (St). That is, the future Russian ruble
value would be much lower.
2. Yes, it does support the PPP in general. However, the decline

in the Russian ruble value usually does not go far enough as
the PPP predicts. The PPP relationship is distorted by
politics. The central bank does not allow the Russian ruble’s
official exchange rate to decline too much in a period of time
so that the government ‘looks’ better.
UNIT 2 41
2.4 The Theory of International Fisher

Effect
Objectives
1. Explain the International Fisher Effect (IFE) theory, and its implications
2. Compare and contrast between IFE, PPP and IRP.
Introduction
This section explains the International Fisher Effect (IFE) theory and its
implications for exchange rate. Essentially, the Fisher effect hypothesises that real
interest rate is stable. Hence, real interest rate is equal to the difference between
the nominal interest rate and the inflation rate. It uses interest rate rather than
inflation rate differentials to explain why exchange rate change over time.
Derivation
The Fisher effect in finance or economics is described as:
(1 + i) = (1 + r)(1 + I )
where
i = nominal interest rate
r = real interest rate (r)
I = inflation rate (I )
or
(1 + I) = (1 + i)(1 + r)
The International Fisher Effect (IFE) goes a step further. It assumes that real interest
rates across countries are stable and equal. This is certainly a strong assumption. I
have provided a relatively simple derivation here.
Consider relative PPP in equation (7),

St + 1 − St (1 + Ih) − (1 + If )
Exchange rate changes, et = = (7)
St 1 + If
(1 + Ih) (1 + If )
Substituting (1 + Ih) = and (1 + If ) = into equation (7),
(1 + r) (1 + r)
St + 1 − St (1 + Ih)/(1 + r) − (1 + If )/(1 + r)
Exchange rate changes, et = =
St (1 + If )/(1 + r)
Ih − If
= (8)
(1 + If )
et ≅ ih − if if if is small.
IFE as described in equation (8) is rather handy if it holds. From equation (8),
you can also use nominal interest rate to explain the exchange rate changes
(i.e., appreciation or depreciation). For instance, if it is expected that if > ih, et
becomes negative, a depreciation of foreign currency is expected.
Numerical examples
• Assume that the one-year certificate of deposit rate in a Hong Kong bank
is 10% and the same one-year certificate of deposit rate in a Singapore bank
is 13%. For the actual returns of these two investments (both certificates
of deposit) to be the same from the perspective of investors in Hong Kong,
what would be the appreciation or depreciation rate of the Singapore dollar?
Answer
Using the IFE approximation in equation (8),
et ≅ ih − if = 10% − 13% = −3%
or the Singapore dollar has to depreciate by 3%.

UNIT 2 43
• Assume that the Australian dollar’s spot rate is $0.90/A$ and that the
Australian and US one-year interest rates were initially 6%. Then the
Australian central bank raises the Australian one-year interest rate to 11%,
while the US one-year interest rate remains the same. Using this
information and the IFE, forecast the spot rate for Australian dollars one
year ahead (i.e., the expected one-year forward rate).
Answer
Because the interest rate levels are high, we use the exact equation (8),
(ih − if )
et ≅
(1 + if )
= (6% − 11%)/(1 + 11%)
= −4.5%
Future spot rate = $0.90/A$ × (1 − 4.5%) = $0.8595/$
Why IFE does not occur

IFE relies on the validity of relative PPP. If relative PPP does not hold, you cannot
start with et ≅ Ih − If in the derivation of equation (8). In addition, there may be
other factors such as government controls that prevent the adjustment of the
exchange rate. This means that IFE is unlikely to hold in the short run. In the long
run however, when PPP occurs, IFE is more likely to exist.
The following reading will help you understand the IFE. This material will
supplement the discussion of IFE in this unit.
This completes the fourth lesson of Unit 2. In this lesson, you have been introduced
to theory of International Fisher Effect (IFE), an extension of the Fisher Effect
theory. IFE provides a useful guide on the spot exchange rate changes by referring to
differential in the interest rates across two markets. Similar to PPP, empirical studies
on IFE find that this theory is unlikely to hold in the short run. You are advised to read
the following article in WOU MyDigitalLibrary, E-course reserves to reinforce your
understanding on IFE.
Reading

(pages 256 – 261).
Activity 2.8
Answer the following questions:
1. Assume the spot exchange rate of the Singapore dollar is

$0.70/S$. The one-year interest rate is 11% in the US and
7% in Singapore. What would be the spot rate in one year
according to the International Fisher Effect?
2. Why does the International Fisher Effect (IFE) suggest that

Asian countries (e.g., Thailand or Indonesia) would not
attract foreign investment before the Asian crisis despite the
high interest rate?
Comparison of the PPP, IFP and IRP theory

Let us list the relative PPP, IFE, and IRP equations again.
• Relative PPP:
St + 1 − St (I − I )
= h f (7)
St (1 + If )
• IFE:
St + 1 − St (i − i )
= h f (8)
St (1 + if )
• IRP:
Ft − St (i − i )
= h f (8)
St (1 + if )
If you combine IFE and IRP together, the right hand sides of the two equations
are the same. Then, Ft must be the same as St + 1, i.e., the forward exchange rate is
the same as the spot exchange rate in the future. Certainly, since the theories may
deviate from the relationship slightly, it would be more an ‘average’ relationship.
Therefore, on average, we can consider the forward exchange rate as the future
spot exchange rate. This is commonly referred to as the forward rate being an
unbiased forecast of the future spot rate. Practically, we can examine the forward
rate as of today to have a good idea of the future spot exchange rate.
UNIT 2 45
If you combine IFE and relative PPP together, the left-hand sides of the two
equations are the same. And if If and if are small, then (Ih − If ) is the same as
(ih − if ). That is, the inflation rate differentials would be the same as the interest
rate differentials.
A summary diagram
The following diagram in Figure 2.6 summaries all the theories that you have learnt
in this Unit 2. This is useful for a general view of all the parities simultaneously.
Basically the subject here is exchange rate market, money market and product
(goods and services) market. The exchange rate market comprises spot market
and forward market. From the diagram, the theory that links spot exchange rate
market to product market is PPP. The theory that links the spot exchange rate
market to money market is IFE; while the theory that links the forward exchange
rate market to money market is IRP. On the diagonal, FE links the local money
market to product market while between spot and forward exchange rate market,
the believe is that forward rates are always an unbiased predictor for the spot
rates, but this is not an established theory. In theory, the arbitrage (both covered
and uncovered) activities should keep all these parities to hold equilibrium
always.
Spot exchange
rate
PPP
Forward exchange Prices in goods and

IFE
rate services market
IRP FE
Interest rates in
money market
Figure 2.6 Summary diagram for international parities

Activity 2.9
Assessment of the IFE by Chinese Food Exports Company
The Chinese Food Exports Company exports authentic dried

and canned Chinese food to the United Kingdom. John Lee, the
owner, receives a cheque (denominated in pounds) from his major
customer at the end of each month. John Lee then decides each
month whether to hedge the receipt with a forward contract to
sell pounds for the following month (i.e., to lock in the amount of
Hong Kong dollars to be received).
However, he has questioned whether this decision is worth

the trouble. He remembers that in his international financial
management course at the Open University, the course discussed
the International Fisher Effect (IFE). If IFE holds, the pound
value should change (on average) by an amount that reflects the
differential between the interest rates of Hong Kong and the
United Kingdom. He also recalls that, according to Interest Rate
Parity (IRP), the forward premium (or discount) reflects that
same interest rate differential. If IFE and IRP hold, the results
from hedging with a forward contract should equal the results
from not hedging on average.
Questions
1. In less than 100 words, briefly explain if John is right about

IFE.
2. If you were John Lee, would you spend time trying to decide
whether to hedge the accounts receivable each month?
Summary
In this section, you have been introduced to the theory of

International Fisher Effect (IFE), an extension of the Fisher
Effect theory. The Fisher effect hypothesises noted that the real
interest rate is stable, and hence, the real interest rate is equal to
the difference between the nominal interest rate and the inflation
rate. IFE provides a useful guide on the spot exchange rate
changes by referring to differential in the interest rates across two
markets. Similar to PPP, empirical studies on IFE find that this
theory is unlikely to hold in the short run.
UNIT 2 47
Self-test 2.4
1. Forecast the British pound’s value in a year using the IFE and
the exchange rate between the Hong Kong dollar and the
British pound.
2. Assume that the pound’s value is in equilibrium. Assume that

over the year the British inflation rate is 6% while the
inflation rate of Hong Kong is 4%. Using this information
and the information in Self-test 2.1 question (1), determine
how the pound’s value would change over the year.
Feedback
Activity 2.8
1. According to IFE, the interest rate differential is 4% in USD

dollar favour (11% − 7%). If the interest rate parity rule is
applied, the USD dollar is expected to depreciate by equivalent
4% one year from now. It should be $0.70 (1 + i), whereby i
is 4%. That means the spot rate one year from now I $0.70
(1.04) = $0.728 to one Singaporean Dollar.
2. Although the interest rates in these Asian countries are high

(i.e., high if ), according to IFE, these countries’ currencies
would depreciate in the near future. If an investor converts
his or her foreign currencies (e.g., dollars) into these Asian
countries’ currencies, the exchange rate risk is high, i.e., the
depreciation of these Asian countries’ currencies may be so
high that it can more than offset the high interest rate gain.
In addition, these Asian countries’ currencies do not have
forward markets in their currencies, hence, no covered Interest
Rate Parity transaction is possible. Overall, foreign investors
are very cautious despite the high interest rates in these Asian
countries.
Activity 2.9
1. According to IFE, exchange rate changes become et = (ih − if )/

(1 + if ). That is, on average, if the interest rate in the UK (if )
goes higher relative to the interest rate in Hong Kong (ih),
then the pound will depreciate (et becomes negative). His
understanding of IFE is correct. However, the high interest
rate does not help John Lee unless he can leave the sales
revenue in British pounds for a period of time so that he earns
high interest to compensate for the loss in Hong Kong dollars
after the exchange of British pounds to Hong Kong dollars.
2. Yes. The exchange movements may change every month.

Interest rate changes may be different every month. Given all
these rapid changes, John Lee may or may not need to do a
forward contract to sell British pounds each month.
UNIT 2 49
Summary of Unit 2
Summary
In Unit 2, three theories were discussed. Interest Rate Parity (IRP)

explains the exchange rates of two countries’ currencies by the
interest rate differences in the countries. Purchasing Power Parity
(PPP) explains the exchange rates of two countries’ currencies by
the price differences in the countries. The International Fisher
Effect (IFE) explains the impact of the inflation rate difference
on two countries’ interest rates.
All three theories are related to one another such that the theories
imply the same relationship among exchange rates, interest rates,
and inflation rates. It is important for financial professionals
to know about the relationship. As an international business
professional, one has to deal with decisions in which the exchange
rate is an important consideration. With a better knowledge of
how the exchange rate is determined and of its dynamics in the
market, we can make sound and profitable business decisions.
The knowledge of the relationship among the three rates is critical
for the business sector in an open economy such as Malaysia.
For example, any import/export company in Malaysia has to
factor in the exchange rate of the Malaysian Ringgit with other
currencies in addition to the interest rate and inflation rate
factors in evaluating any business transaction. Both the static and
dynamic aspects of these three rates have to be considered
together.
At this point, you should know the three theories of exchange

rate and its underlying factors. You should be able to utilise your
knowledge from Unit 2 for any international business decision
making.
1. Arbitrage can be simply defined as taking a profit on a

discrepancy in quoted prices. Arbitrage opportunities occur
when there is a product mispricing in one of the locations or
markets but the product must be homogeneous, there should
be no barriers in mobility and transportation cost is zero.
2. Locational arbitrage refers to discrepancy in prices in two

different locations, or two different markets. Within the
context of exchange rate movement, locational arbitrage
means capitalising on the differences in exchange rates
between locations.
3. Triangular arbitrage means capitalising on discrepancies in

three locations or markets. Within the context of exchange
rate movement, triangular arbitrage occurs when a quoted
cross exchange rate is not equal to the exchange rate that
should exist in equilibrium.
4. Within the context of exchange rate movement, covered

interest rate arbitrage (CIA) capitalising on discrepancies
between the forward rates and the interest rate differential.
CIA involves investing in a foreign country to make a profit
and at the same time covering against exchange rate risk by
a forward exchange rate contract, thus the position is
absolutely unexposed to currency risk.
5. Uncovered interest rate arbitrage (UIA) is a deviation from

CIA. UIA is very similar to CIA, except that the position is
not covered by a forward contract and hence exposed to
currency risk.
6. Interest Rate Parity (IRP) explains the relationship between

forward markets and the international money markets. The
IRP states that the difference in the interest rates for assets of
similar risk and maturity in two markets should be equal to
the forward discount or forward premium for the exchange
rate of the two national currencies, but opposite in direction,
assuming there is no transportation cost.
7. Purchasing Power Parity (PPP) explains the relationship

between the foreign exchange markets and the goods and
services markets. The absolute version of PPP states that the
difference in the prices for goods and services of similar
quality in two markets should be equal to the exchange rate of
the two national currencies, assuming there are no barriers in
mobility of the goods and services, and also no transportation
cost. The relative version of PPP restates the relationship into
changes of prices for goods and services with changes in
exchange rates.
8. International Fisher Effect (IFE) explains the relationship

between the foreign exchange markets and the international
money markets. The IRP states that the difference in the
interest rates for assets of similar risk and maturity in two
markets should be equal to the changes in the spot exchange
rate of the two national currencies, but opposite in direction,
assuming there is no transportation cost. IFE is an extension
from Fisher effect (FE) which explains real interest rate as the
difference between the nominal interest rate and the inflation
rate.
UNIT 2 51
9. International arbitrages activities always keep check on all

these parities to ensure they work in equilibrium.
UNIT 2 53
Suggested Answers to Self-tests
Feedback
Self-test 2.1
1. Theoretical cross exchange rate between the pound and the

Australian dollar:
= HK$15.38/£ ÷ HK$7.47/A$
= A$2.06/£ which is the same as the cross rate quoted.
Therefore, triangular arbitrage is not feasible.
2. First, we need to check whether covered interest arbitrage is

feasible by the following steps:
• Use IRP to check if the forward rate from IRP calculations

is the same as the reported forward rate.
• For HK$ and £:

Forward rate = S × (1 + ih)/(1 + if )
= HK$15.38/£ × (1.08)/(1.09)
= $15.24/£.
• The calculated forward rate is different from the reported

forward rate of HK$15.40/£ which suggests that covered
interest arbitrage in Hong Kong dollars and pounds is
feasible.
Then, we can conduct the following steps to calculate the

profit we can make by covered interest arbitrage:
• Convert HK$10,000 to pounds at the current spot rate:

⇒ amount of pounds received = HK$10,000 ÷ HK$15.38/£
= £650.20.
• Deposit the £650.2 in a British bank at 9% for one year,

expected principal plus interest = £650.2 × (1 + 9%) =
£708.72.
• Simultaneously set up a one-year forward contract to sell

£708.72 at the forward exchange rate of HK$15.40/£.
• One year later, honour the forward contract and collect

Hong Kong dollars. Amount of Hong Kong dollars
received = £708.72 × HK$15.40/£ = HK$10,914.29
which represents a 9.14% return. The percentage return
is higher than the 8% offered in Hong Kong.
Self-test 2.2
1. $1,000,000/$.80 = C$1,250,000 × (1.04) = C$1,300,000 ×

$.79 = $1,027,000
Yield = ($1,027,000 − $1,000,000)/$1,000,000 = 2.7%, which

exceeds the yield in the U.S. over the 90-day period.
The Canadian dollar’s spot rate should rise, and its forward
rate should fall; in addition, the Canadian interest rate may
fall and the U.S. interest rate may rise.
2. Disagree. If at any point in time, interest rate parity does not

exist, covered interest arbitrage could earn excess returns
(unless transaction costs, tax differences, etc., offset the excess
returns).
3. The premium will decrease in order to maintain IRP, because

the difference between the interest rates is reduced. We would
expect the premium to change because as U.S. interest rates
decrease, U.S. investors could benefit from covered interest
arbitrage if the forward premium stays the same. The return
earned by U.S. investors who use covered interest arbitrage
would not be any higher than before, but the return would
now exceed the interest rate earned in the U.S. Thus, there
is downward pressure on the forward premium.
Self-test 2.3
1. PPP suggests that the purchasing power of a consumer will

be similar when purchasing goods in a foreign country or in
the home country. If inflation in a foreign country differs
from inflation in the home country, the exchange rate will
adjust to maintain equal purchasing power.
UNIT 2 55
2. One method is to choose two countries and compare the

inflation differential to the exchange rate change for several
different periods. Then, determine whether the exchange rate
changes were similar to what would have been expected under
PPP theory.
A second method is to choose a variety of countries and

compare the inflation differential of each foreign country
relative to the home country for a given period. Then,
determine whether the exchange rate changes of each foreign
currency were what would have been expected based on the
inflation differentials under PPP theory.
A limitation in testing PPP is that the results will vary with

the base period chosen. The base period should reflect an
equilibrium position, but it is difficult to determine when
such a period exists.
3. According to PPP, the exchange rate of the pound will

depreciate by 4.7 percent. Therefore, the spot rate would
adjust to $1.73 × [1 + (−0.0467)] = $1.649.
Self-test 2.4
1. International Fisher Effect:

St + 1 − St (i − i )
= h f
St (1 + if )
St + 1 − 15.38 (0.08 − 0.09)

=
15.38 (1 + 0.09)
St + 1 = HK$ 15.24/£
2. According to relative PPP, percentage change in value equals

(Ih − If )
et =
(1 + If )
(0.04 − 0.06)
=
(1 + 0.06)
= −1.8868%
that is, the value of British pounds depreciates by 1.8868%.

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UNIT 2 i

The relationship between exchange rates, interest rates and inflation

EXTERNAL COURSE ASSESSOR

© 2010 Wawasan Open University

First revision 2015

Wawasan Open University [DU013(P)]

2.1 International arbitrage and realignments 3

The concept of arbitrage 3

Covered and uncovered Interest arbitrage 9

Suggested answers to activities 16

2.2 The theory of interest rate parity 19

Does IRP hold? 26

Suggested answers to activities 29

2.3 The theory of purchasing power parity 31

Rationale behind PPP theory 35

Why PPP does not occur 35

PPP in the long run 36

Suggested answers to activity 39

2.4 The theory international Fisher effect 41

Why IFE does not occur 43

Comparison of the PPP, IFP and IRP Theory 44

Suggested answers to activities 47

Suggested answers to self-tests 53

I n Unit 1 we looked at some basic concepts of international financial management

1. Explain the conditions that will result in various forms of international

2. Explain the realignments that will occur in response to various forms of

3. Calculate the profit gained from various forms of international arbitrage.

2.1 International Arbitrage and

1. Compare and contrast the various types of arbitrage.

2. Discuss the conditions that will result in various forms of international

3. Critically analyse the realignments that will occur in response to various

4. Calculate the profit gained from various forms of international arbitrage.

The concept of arbitrage

• Covered and uncovered interest arbitrage

Arbitrage can be simply defined as taking a profit on a discrepancy in quoted

Public Bank Maybank

Table 2.1 Foreign exchange quotation

• Profit = RM0.645 − RM0.640 = RM0.005

Public Bank Maybank

RM0.64 million × RM0.640/Y × RM0.645/Y

= 10 million Yuan = RM64.5 million

The difference = RM64.5 million − RM64 million = RM0.5 million

Figure 2.1 Locational arbitrage

What will be the likely consequences? A lot of investors or institutions will do

The answers depend on a number of factors. First, information flow plays an

Answer the following questions.

Assume the following information:

Bid price of Swiss francs $0.961/SF $0.958/SF

Given this information, is locational arbitrage possible? If so,

Currencies Bid exchange rate Ask exchange rate

British pounds exchange $1.982/£ $1.983/£

How do we identify the triangular arbitrage opportunity? The above triangular

Consider the following steps as illustrated in Figure 2.2:

Assume Mr. A borrow $10,000 from US bank.

• Convert $10,000 to Euros: $10,000 ÷ $1.5595/€ = €6,412.3116; note that

• Convert €6,412.3116 to pounds × (1/1.2680) = £5057.03:

• Convert £5,057.03 to dollars: $1.982/£ × £5,057.03 = $10,023.03; note

• Profit = $10,023.03 − $10,000 = $23.03;

• % profit = $23.03/$10,000 = 0.23%.

€6,412.3116 ÷ €1.2680/£ £5,057.03 × $1.982/£

Figure 2.2 Triangular arbitrage

Please read the following article in WOU MyDigitalLibrary,

After reading, please attempt the following activity.