Chapter 7

International Arbitrage and

Interest Rate Policy

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Chapter Objectives
• To explain the conditions that will result in
various forms of international arbitrage,
along with the realignments that will occur
in response.
• To explain the concept of interest rate
parity, and how it prevents arbitrage
opportunities.

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 International Arbitrage (1)
• Arbitrage can be loosely defined as
capitalizing on a discrepancy in quoted
prices to make a riskless profit.
• The effect of arbitrage on demand and
supply is to cause prices to realign, such
that no further risk-free profits can be
made.

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 International Arbitrage (2)
• As applied to foreign exchange and
international money markets, arbitrage
takes three common forms:
– locational arbitrage
– triangular arbitrage
– covered interest arbitrage

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Locational Arbitrage
• Locational arbitrage is possible when a
bank’s buying price (bid price) is higher than
another bank’s selling price (ask 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 @ $0.64, and sell it to Bank
D @ $0.645 Profit = $.005/NZ$.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Triangular arbitrage
• Triangular arbitrage is possible when a cross
exchange rate quote differs from the rate calculated
from spot rate quotes.
• Assume you have the following quotations
– 1 000 000 $ to play with
– Westminster Bank: $ 1.5500/£
– Shanghai Bank € 1.5000/£
– Wells Fargo $ 1.0600/€
• Is triangular arbitrage possible ?
– Cross rate $/€ = 1.55/1.50 = 1.0333
– Sell $ where it`s expensive, buy it back where it`s cheap

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Triangular arbitrage

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Covered Interest Arbitrage (1)
• Covered interest arbitrage is the process
of capitalizing on the interest rate
differential between two countries while
covering for exchange rate risk.
• Covered interest arbitrage tends to force a
relationship between forward rate
premiums and interest rate differentials.

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Covered Interest Arbitrage (2)
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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Covered Interest Arbitrage
• Assume you have 1 000 000 USD for 90 d
• Swiss franc interest rate 4.00% p.a.
• US $ interest rate 8.00 % p.a.
• Spot rate = 1.4800 CHF/$, 90 day forward
= 1.4655 CHF/$
• Is arbitrage possible ?

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Interest Rate Parity

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Interest Rate Parity
1 000 000 USD sold for CHF 1,4800 1 480 000
Money market for 90 days 4,00 % p.a. 14 800
Future value after 90 days 1 494 800
Exchange back for USD 1,4655 1 019 993
Future value 90 days in the USA 8,00 % p.a. 1 020 000
Profit 7

F (1  i h ) t 1,4655 1,01
Equilibrium when  t
here 
S (1  i f ) 1,4800 1,02

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Interest Rates
and Exchange Rates
• A deviation from covered interest arbitrage is uncovered
interest arbitrage (UIA). In this case, investors borrow in
countries and currencies exhibiting relatively low interest
rates and convert the proceed 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 and 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 10 000 000. Expected
spotrate in 1 year is also Y120/$
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Uncovered Interest Arbitrage (UIA): The Yen Carry
Trade

Cost and Management Accounting: An Introduction, 7th edition

Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Interest Rate Parity (IRP)
• As a result of market forces, the forward
rate differs from the spot rate by an
amount that sufficiently offsets the
interest rate differential between two
currencies.
• Then, covered interest arbitrage is no
longer feasible, and the equilibrium state
achieved is referred to as interest rate
parity (IRP).
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Derivation of IRP
• We use the following symbols
– Amount of home currency invested initially is
Ah which grows to An after investing in foreign
deposit
– Spot rate (direct quote) is S and forward rate
F
– Interest rate is ih at home and if in the foreign
country
– Return on investing abroad is R
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 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

Ah (1  i f )(1  p )  Ah
R
Ah
R  (1  i f )(1  p)  1
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Derivation of IRP
• For IRP to hold domestic and foreign returns are
equal, i.e. R = ih
(1  i f )(1  p )  1  ih
(1  i f )(1  p )  1  ih
(1  ih )
(1  p) 
(1  i f )
(1  ih )
p 1
(1  i f )
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Interest Rate Parity Defined
Or if you prefer,
1 + ih F
=
1 + if S

IRP is sometimes approximated as

ih – i f = F – S
S
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 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  - .0094
• If S = £.07/peso, then
6-month forward rate = S  (1 + p)
 .07  (1 _ .0094)
 £.06934/peso
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Graphic Analysis of Interest Rate Parity (1)
Interest Rate Differential (%)
home interest rate – foreign interest rate
4

Z IRP line
2
B X

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
Y
A -2

W
International Financial Management, 2nd edition
-4
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
 Graphic Analysis of Interest Rate Parity (2)
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Zone of potential
covered interest IRP line
arbitrage by
foreign investors 2

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
Zone of potential
- 2 covered interest
arbitrage by
local investors
-4
International Financial Management, 2nd edition, Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA
 Test for the Existence of IRP
• To test whether IRP exists, collect actual
interest rate differentials and forward
premiums for various currencies, and plot
them on a graph.
• IRP holds when covered interest arbitrage
is not possible or worthwhile.

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Interpretation of IRP
• When IRP exists, it does not mean that
both local and foreign investors will earn
the same returns.
• What it means is that investors cannot use
covered interest arbitrage to achieve
higher returns than those achievable in
their respective home countries.

Cost and Management

International
Accounting:
FinancialAn
Management,
Introduction,
2nd7edition
th edition

Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
 Does IRP Hold? (1)
Forward Rate
Premiums with the
US $ and
Interest Rate
Differentials for
Seven Currencies
 Does IRP Hold? (2)
• 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 characteristics of
foreign investments, such as transaction
costs, political risk, and differential tax
laws.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
 Considerations When
Assessing IRP (1)
Transaction Costs
iH – iF
IRP line
Zone of potential
covered interest
arbitrage by
foreign investors Zone of
p potential
Zone where covered
covered interest interest
arbitrage is not arbitrage
feasible due to by local
transaction costs investors
International Financial Management, 2nd edition
Jeff Madura and Roland Fox
ISBN 978-1-4080-3229-9 © 2011 Cengage Learning EMEA