1) International arbitrage involves capitalizing on price discrepancies between currencies in different locations without taking on risk. Locational arbitrage occurs when a currency can be bought cheaper in one location and immediately sold at a higher price elsewhere. 2) Triangular arbitrage exploits temporary differences between cross-exchange rates of three currencies. Covered interest arbitrage takes advantage of interest rate differentials between countries while hedging against exchange rate risk. 3) Interest rate parity exists when the forward exchange rate offsets the interest rate advantage of one country over another, eliminating riskless profits from covered interest arbitrage. This equalizes returns between countries.

1. CHAPTER – 7
INTERNATIONAL ARBITRAGE &
INTEREST RATE PARITY

2. International Arbitrage
• Arbitrage can be defined as capitalizing on a
discrepancy in quoted prices.
• The funds invested are not tied up and no risk is
involved.
• In response to the imbalance in demand and
supply resulting from arbitrage activity, prices
will realign very quickly, such that no further
risk-free profits can be made.

3. • Locational arbitrage is 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.
• Locational arbitrage is possible when a bank’s
buying price (bid) is higher than another bank’s
selling price (ask) for the same currency.
International Arbitrage

4. • Locational arbitrage Example:
1.Buy NZ$ from Bank C @ $.640, and
2.Sell it to Bank D @ $.645.
3.Profit = $.005/NZ$.
International Arbitrage
Bank C Bid Ask Bank D Bid Ask
NZ$ $0.635 $0.64 NZ$ $0.645 $0.65

5. • Triangular Arbitrage in which currency
transactions are conducted in the spot market to
capitalize on a discrepancy in the cross exchange
rate between two currencies.
• This is possible, if quoted cross exchange rate
differs from the appropriate cross exchange rate.
• Example: Bid Ask
British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $0.20 $0.202
£ MYR 8.1 MYR 8.2
International Arbitrage

6. • Steps:
1. Buy £ @ $1.61,
2. convert @ MYR 8.1/£,
3. then sell MYR @ $.200.
4. Profit = $.01/£. (8.1×.2=1.62)
• When the exchange rates of the currencies are
not in equilibrium, triangular arbitrage will force
them back into equilibrium.
International Arbitrage

7. • 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.
International Arbitrage

8. • Example:
Fund available: $800,000
£ spot rate = 90-day forward rate = $1.60
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4%
•Steps:
1.Convert $ to £ at $1.60/£ and invest £ at 4%.
2.Engage in a 90-day forward contract
3.Fulfill the forward contract on maturity and sell £ at
$1.60/£.
4.Determine the yield earned on arbitrage.
International Arbitrage

9. • As many investors capitalize on covered interest
arbitrage, there is:
– Upward pressure on the spot rate and
– Downward pressure on the 90-day forward rate.
• Once the forward rate has a discount from the spot
rate that is about equal to the interest rate
advantage, covered interest arbitrage will no
longer be feasible.
International Arbitrage

10. Example:
• Fund available: $800,000
• Spot rate of £ = $1.62
• 90-day forward rate = $1.5888
• U.S. 90-day interest rate = 2%
• U.K. 90-day interest rate = 4%
International Arbitrage

12. Interest Rate Parity (IRP)
• Sometimes market forces cause the forward
rate to differ from the spot rate by an amount
that is sufficient to offset the interest rate
differential between the two currencies.
• Then, covered interest arbitrage is no longer
feasible, and the equilibrium state achieved is
referred to as interest rate parity (IRP).

13. •
i.e.
• forward =
(1 + home interest rate) –1
premium (1 + foreign interest rate)
Determining the Forward Premium

14. Example:
• Suppose 6-month ipeso = 6%, i$ = 5%.
• From the U.S. investor’s perspective,
forward premium = (1.05/1.06) – 1 ≈ -.0094
• If S = $.10/peso, then
6-month forward rate = S × (1 + p)
≈ .10 × (1
_
.0094)
≈ $.09906/peso
• Such a discount would offset the interest rate
advantage of the peso.
Determining the Forward Premium

15. 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.