International Corporate Finance

11th Edition
by Jeff Madura

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 International Arbitrage And Interest Rate
7 Parity
Chapter Objectives

 Explain the conditions that will result in various forms of

international arbitrage and the realignments that will occur in
response
 Explain the concept of interest rate parity
 Explain the variation in forward rate premiums across maturities
and over time

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 International Arbitrage

 Defined as capitalizing on a discrepancy

in quoted prices by making a riskless
profit.
 Arbitrage will cause prices to realign.
 Three forms of arbitrage:
 Locational arbitrage
 Triangular arbitrage
 Covered interest arbitrage

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 Locational Arbitrage

1. Defined as the process of buying a currency

at the location where it is priced cheap and
immediately selling it at another location
where it is priced higher. (See Exhibit 7.1)
2. Gains from locational arbitrage are based on
the amount of money used and the size of
the discrepancy. (See Exhibit 7.2)
3. Realignment due to locational arbitrage
drives prices to adjust in different locations
so as to eliminate discrepancies.

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 Exhibit 7.1 Currency Quotes for Locational
Arbitrage Example

5
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 Exhibit 7.2 Locational Arbitrage

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 Triangular Arbitrage

1. Defined as currency transactions in the spot

market to capitalize on discrepancies in the
cross exchange rates between two
currencies. (See Exhibits 7.3, 7.4, & 7.5)
2. Accounting for the Bid/Ask Spread:
Transaction costs (bid/ask spread) can reduce
or even eliminate the gains from triangular
arbitrage.
3. Realignment due to triangular arbitrage forces
exchange rates back into equilibrium. (See
Exhibit 7.6)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 7.3 Example of Triangular Arbitrage

8
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 7.4 Currency Quotes for a Triangular
Arbitrage Example

9
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 7.5 Example of Triangular Arbitrage
Accounting for Bid/Ask Spreads

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 7.6 Impact of Triangular Arbitrage

11
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 Covered Interest Arbitrage

1. Defined as the process of capitalizing on the

interest rate differential between two countries
while covering your exchange rate risk with a
forward contract.
2. Consists of two parts: (See Exhibit 7.7)
a. Interest arbitrage: the process of capitalizing on the
difference between interest rates between two
countries.
b. Covered: hedging the position against interest rate
risk.
3. Realignment due to covered interest arbitrage
causes market realignment.
4. Timing of realignment may require several
12 transactions before realignment is completed.
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 Exhibit 7.7 Example of Covered Interest Arbitrage

13
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 SUMMARY

 Locational arbitrage may occur if foreign exchange

quotations differ among banks. The act of locational
arbitrage should force the foreign exchange
quotations of banks to become realigned, and
locational arbitrage will no longer be possible.
 Triangular arbitrage is related to cross exchange
rates. A cross exchange rate between two currencies
is determined by the values of these two currencies
with respect to a third currency. If the actual cross
exchange rate of these two currencies differs from the
rate that should exist, triangular arbitrage is possible.
The act of triangular arbitrage should force cross
exchange rates to become realigned, at which time
triangular arbitrage will no longer be possible.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.