international arbitrage and interest rate parity

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International Financial Management 10th Edition

by Jeff Madura

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7International Arbitrage And Interest Rate Parity

Chapter ObjectivesThis chapter will:

A. Explain the conditions that will result in various forms of

international arbitrage and the realignments that will occur

in response

B. Explain the concept of interest rate parity

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International Arbitrage

1. Defined as capitalizing on a discrepancy in quoted prices by making a riskless profit.

2. Three forms of arbitrage:a. Locational arbitrageb. Triangular arbitragec. 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.

2. Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy.

3. Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies.

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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.

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.

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Exhibit 7.3 Example of Triangular Arbitrage

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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: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 transactions before realignment is completed.

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Exhibit 7.7 Example of Covered Interest Arbitrage

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Exhibit 7.8 Comparing Arbitrage Strategies

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Interest Rate Parity

In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies.

rateinterest foreign rateinterest home

premium forward where

111

f

h

f

h

iip

iip

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Determining the Forward Premium

The relationship between the forward premium (or discount) and the interest rate differential according to IRP is simplified in an approximated form:

rateinterest foreign rateinterest home

dollarsin ratespot dollarsin rate forward

discount)(or premium forwardwhere

f

h

fh

ii

S Fp

iiS

SFp

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Exhibit 7.9 Illustration of Interest Rate Parity

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Interpreting Exhibit 7.9 Illustration of Interest Rate Parity

1. Points representing a discount: points A and B2. Points representing a premium: points C and D3. Points representing IRP: points A, B, C, D4. Points below the IRP line: points X and Y

a. Investors can engage in covered interest arbitrage and earn a higher return by investing in foreign currency after considering foreign interest rate and forward premium or discount.

5. Points above the IRP line: point Za. U.S. investors would achieve a lower return on a foreign

investment than on a domestic one.

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Considerations When Assessing Interest Rate Parity1. Transaction costs2. Political risk3. Differential tax laws

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Exhibit 7.12 Relationship between the Interest Rate Differential and the Forward Premium