Madura: International Financial Management Chapter 7

International Arbitrage
Chapter
7
International Arbitrage And • Arbitrage can be loosely defined as
Interest Rate Parity capitalizing on a discrepancy in quoted
prices.
• prices will realign very quickly, such that
no further risk-free profits can be made.

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Common Forms of Arbitrage Locational Arbitrage

• Locational Arbitrage. • Locational arbitrage is possible when a

• Triangular Arbitrage. bank’s buying price (bid price) is higher
than another bank’s selling price (ask
• Covered Interest Arbitrage. price) for the same currency.
• Example:
Bank C Bid Ask Bank D Bid Ask
NZ$ $.635 $.640 NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to
Bank D @ $.645. Profit = $.005/NZ$.
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Triangular Arbitrage Triangular Arbitrage

• Involves three currencies. • Triangular arbitrage is possible when a

• Steps: cross exchange rate quote differs from the
rate calculated from spot rates.
¤ Purchasing currency X by currency Y
• Cross Exchange Rate is the relationship
¤ Selling currency X for currency Z. between two currencies that are different
from one’s base currency.

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Madura: International Financial Management Chapter 7

Cross Exchange Rate Triangular Arbitrage

• Cross Exchange Rate for £: • Example: Bid Ask

British pound (£) $1.60 $1.61
Value for X in £ Malaysian ringgit (MYR) $.200 $.201
Value for Y in £ British Pound (£) MYR8.1 MYR8.2
Buy £ @ $1.61, convert @ MYR8.1/£, then
sell MYR @ $.200. Profit = $.05/£.

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Triangular Arbitrage Covered Interest Arbitrage

$ • Covered interest arbitrage is the process

Value of Value of of capitalizing on the interest rate
£ in $ MYR in $ differential between two countries, while
covering for exchange rate risk.
£ MYR
Value of
£ in MYR
• Exchange rate risk is covered by a forward
contract.
• When the exchange rates of the currencies
are not in equilibrium, triangular arbitrage will
force them back into equilibrium.
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Covered Interest Arbitrage

Covered Interest Arbitrage
Strategies to follow:
Example: • On day 1, convert your US dollars to Pounds
to set up a deposit account in a British Bank.
• You desire to capitalize on relative high
rates of interest in the UK and have funds • On day 1, engage in a forward contract to sell
available for 90 days. pounds 90 days forward.
• Interest rate is fixed. • In 90 days when the deposits matures,
• Only the exchange rate is uncertain. convert the pounds to US dollars at the rate
that was agreed upon in the forward contract.

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Madura: International Financial Management Chapter 7

Covered Interest Arbitrage

Assume the following information:
• You have $8,00,000 to invest.
• The current spot rate of the pound is $1.60.
• The 90 day forward rate of the pound is $1.60
• The 90 day interest rate in the US is 2%
• The 90 day interest rate in the UK is 4%
¤ How are you going to use the CI arbitrage
and what will be your gain from that?
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International Arbitrage
• Locational arbitrage ensures that quoted
exchange rates are similar across banks
in different locations.
• Triangular arbitrage ensures that cross
exchange rates are set properly.
• Covered interest arbitrage ensures that
forward exchange rates are set properly.
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International Arbitrage

• Any discrepancy will trigger arbitrage,

which will then eliminate the discrepancy.
Arbitrage thus makes the foreign
exchange market more orderly.

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