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Lecture 12

Ch No 7 International Arbitrage and Interest rate Parity

The shop A will raise its price due to high demand. In some cases it does not required any kind of funds to be tied up for a length of time and does not involve any risk.International arbitrage          What is Arbitrage ???? Arbitrage can be defined as capitalizing on a discrepancy in quoted prices by making a risk-less profit. the investor will buy the coins at shop A and will sell it to the shop B and will earn a profit equal to what rate?????? The act of Arbitrage will cause prices to realign. The selling price at coin shop A is 120 $ while Buying price at shop B is $130. Example: two coin shops A and B. Why?????? Due to receiving of surplus of coins as Arbitrage occurs. The shop B will reduce its bid price.How transaction occurs? Obviously. .

. Look at examples on book. Commercial banks provide foreign exchange quotes about the same rate on the currencies. Market forces (demand and supply) will force realignment. When quoted rates vary among banks. It is the process to buy the currency at the region where is priced cheap and immediately selling it another location where it is priced higher. the banks may price that currency at different rates. Shopping around the location may not lead to Arbitrage.Forms of Arbitrage.          Locational Arbitrage. It means they are using Locational Arbitrage. participants can capitalize on discrepancy. If the demand and supply conditions for a particular currency vary among banks.

it is a break even point). Locational arbitrage is conducted by banks or other foreign exchange dealers whose computers continuously monitor the quotes provided by other banks. the bid price of one bank must be higher than the Ask price of the other bank .Forms of Arbitrage. then no discrepancy (i. For example if Ask of bank A is $1. What is the role of Bid and Ask spread???? The bid price of one bank must be higher than the Ask price of the other bank.61. In short to achieve profits from Locational Arbitrage.61 and Bid of the bank B is also $1.e.         Locational Arbitrage The gain is risk free in that you knew when you purchased the currency how much you could sell them for? You did not tie funds for any length of time.

.640 $ at the Akron Bank. Use US dollars to buy NZ dollars for .Locational Arbitrage          Gains from locational Arbitrage. Take the NZ dollars purchased from the Akron Bank and sell them to south Bank in exchange for US dollars. 1.645 & Ask is . What is round trip transaction???????? For example: Akron Bank Bid for NZ $ is $.640$ and South Bank Bid for NZ $ is $. Size of the discrepancy. Step 2.650$ How the transaction will occur????? Step 1.635 & Ask is . 2. The locational Arbitrage is based upon the amount of money that you use to capitalize on the exchange rate discrepancy.

. the high demand for NZ $ will cause a shortage of NZ$ at the Akron Bank and what will happen????????? The Akron Bank will raise the Price of NZ$. What will happen to South Bank??????? The excess supply of NZ$ in North Bank (resulting from the sales of NZ$ to south Bank in exchange for dollars) will force South Bank to lower down its Bid price. What is role of Technology?????? Technology allows the banks to be electronically connected to foreign exchange quotations at any time.Locational Arbitrage          Realignment due to Locational Arbitrage Quoted prices will react to the locational Arbitrage strategy. This strategy is used by you (if you are the investor) and by other market participants. For example.

For example.60 $ and the Canadian dollar is worth 0.80 / 1.50 If the quoted rate differs from the appropriate cross exchange rate.  . If the British pound is worth 1.80 $.Triangular Arbitrage        It represents the relationship between two currencies that are different from one¶s base currency. you can attempt to capitalize on the discrepancy.80 = 2 What is the Value of C$ in units of Pounds???? Value of C$ in units of £ = 0.60 / 0.60 = 0. then what is the value of British Pound with respect to the Canadian dollar???? Value of £ in units of C$ = 1. What is the Cross-Exchange rate????? In United states the term cross exchange rate refers to the relationship between two non dollar currencies.

1 What process we continue???? Use the pound value in US dollars and MR value in US dollars to develop the cross exchange rate that should exist between the pound and MR. Determine how many dollars will you receive in exchange for Ringitt?? MYR 50625 = 10125 $ based on the Bank¶s quote of 0.60 $ per pound. Q.20 $.1 Ringitt per pound. MYR = 50625 based on the bank¶s quote of 8. Cross exchange rate at 1 £ = MYR 8.60 $ MY Ringgit = . If you have 10. Arbitrage = 125$ .000 dollars how many dollars will you end up with if you implement the Triangular Arbitrage Strategy???? 1. Determine how many Ringitt will you receive by 6250 £ . 3. 2.Triangular Arbitrage             For example.20 $ per Ringitt. Determine the number of Pounds received by your dollars that is 10000 $= 6250 £ that is based on bank quote of 1. Pound = 1.

Accounting for the Bid/Ask Spread There is Bid and Ask quote for each currency. Realignment due to Triangular Arbitrage. There is no uncertainty about the Prices at which you will buy and sell the foreign currencies. The discrepancies assumed here are unlikely to occur within a single bank.free. Triangular Arbitrage does not tie up funds. It means that the Arbitrageur incurs the transaction costs that can reduce or even eliminate the gains from triangular Arbitrage. The realignment will likely occur quickly to prevent continued benefits from Triangular Arbitrage. This strategy is Risk. . Triangular Arbitrage would require three transactions at three separate banks.Triangular Arbitrage           Like Locational Arbitrage .

2. Covered refers to hedging your position against exchange rate risk. Investors mostly use their own funds.Covered Interest Arbitrage. Funds are invested or borrowed locally. It consists of two parts. . covered Interest Arbitrage. Process of capitalizing on the difference between interest rates between two countries. 1.         Covered Interest Arbitrage. It is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk.

sell £ 520000.000 £.000 £ in the British Bank.000 $ to invest.day interest rate in the United Kingdom is 4%. you can fulfill your forward contract obligation by converting your £520000 into 832000 $ (based on the forward contract rate of $1.Covered Interest Arbitrage           Look at the following information. By the time the deposit matures. On day-1. and deposit the 500.60 per pound. The 90-day forward rate of the pound is 1. . The 90.90 days forward. you will have £520000 (including interest). In 90-days when the deposit matures.60$ The 90-day interest rate in the United States is 2 %. How you should proceed????? On day-1 convert the 800.000$ to 500. You have 800.

there is an equilibrium state referred to as Interest rate Parity. When the forward rate is less than the spot rate.Interest Rate Parity (IRP)       When market forces cause interest rates and exchange rates to adjust such that covered Interest Arbitrage is no longer feasible. it implies that the forward rate exhibit the premium. When the forward rate is more than the spot rate. In equilibrium the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential b/w two currencies. . Derivation of the Interest rate Parity????? The relationship between a forward premium (or discount) of a foreign currency and the interest rate representing these currencies according to IRP can be determined as follows. it implies that the forward rate exhibit the discount.

.Derivation of the Interest rate Parity     The amount of the home currency (US. Dollars ) that is initially invested is Ah The spot rate (S) in dollars when the foreign currency is purchased The interest rate on the foreign deposit is (If) The forward rate at which the foreign currency will be converted back to U.S dollars.

. P = 1 + Ih / 1 + If .09906$ Negative sign shows the discount premium.. If the peso¶s spot rate is $0.06 ± 1 P = -. the Peso should exhibit a forward discount of about .. According to IRP line what should be the Forward rate Premium and nature of the Premium????? P = 1 + .0094)= . The US-dollar is the home currency.94 %. while the USdollar exhibit a six-month interest rate of 5 %.05 / 1 + .Forward Premium            The forward rate can be determined by the following method.10 and the forward rate is 0.94% Thus.10 (1 .0094 or . Q.1 If the Mexican Peso exhibits a six-month interest rate of 6%.94% then what is the six-month forward rate? F = S(1+P) ??? = .

. then the foreign currency will show a forward discount. If the forward premium is equal to the interest rate differential. . covered interest rate Arbitrage will not be possible. the IRP relationship suggests that the forward rate should exhibit a discount.The relationship between forward premium and forward discount      The relationship between the forward premium (or discount) and the Interest rate differential according to IRP line can be expressed as P = F ±S /S = Ih ± If If the foreign interest rate exceeds the home interest rate. If the foreign interest rate is less than the home interest rate.

the forward rate should exhibit a discount equal to the interest rate differentials. as representing by the point. When forward discount???? For the situations in which the foreign interest rate exceeds the home interest rate. then the forward rate should exhibit a discount equal to differential (Ih ± If). Points representing a premium.2% as shown by point A. If the home interest rate exceeds the foreign rate by 1%. Points representing a discount. .Graphic Analysis of Interest rate Parity         See figure on book. 1. 2. The situations in which the home interest rate exceeds the foreign rates. C. . For example when the foreign interest rate exceeds the home interest rate . the forward rate should exhibit a premium equal to the differential. then the forward premium should be 1%.

Points below the IRP line. .Graphic Analysis of Interest rate Parity    Points representing IRP line. What happens if the foreign interest rate is 10 % and the local interest rate is 7%??? Interest rate differential is equal to the ³-3%´.cutting the point of intersection. and the forward discount can be represented by the point µX¶ on the graph. Any points lie on the on the diagonal line . Covered interest arbitrage is not possible for the points along the IRP line.      . represent the IRP line. Also assume that the foreign currency exhibits an annualized forward discount of 1%. Then the combined interest rate differential.

This point is to the left of IRP line. This point represents that the foreign interest rate exceeds the home interest rate by 1%. Interest rate differential is equal to the 2%.Graphic Analysis of Interest rate Parity    Take point Y on the graph. Take point Z on the graph.       . Points above the IRP line. High forward premium than the makes up what the investors loses on the lower interest rate. Forward premium is equal to the 4%. This point represents that the US investor will achieve a lower return on the foreign investment than the home investment. While the forward rate exhibits a discount of 3%.

foreign investors could gain through covered interest arbitrage. Differential tax laws. 3. How the home investor benefits????? For the points to the right of (or below) the band. How the foreign investor benefits????? For the points to the left of (or above the band). political risk. If the investor wishes to account for transaction costs then«.What are considerations when assessing interest rate parity?????          1. investor residing in the home country could gain through covered interest arbitrage. The actual point reflecting the interest rate differential and forward premium must be farther from the IRP line to make covered interest arbitrage feasible. 2. Transaction costs. .