INTERNATIONAL FINANCE
Chapter 7 International Arbitrage And Interest Rate Parity

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Chapter Objectives

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the conditions that will result in triangular
arbitrage and the realignments that will follow.

the conditions that will result in covered
interest arbitrage and the realignments that will follow.

the conditions that will result in locational
arbitrage and the realignments that will follow.

the concept of interest rate parity.

the variation in forward rate premiums across
maturities and over time.

International Arbitrage

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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

Locational Arbitrage

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Defined

Gains from locational arbitrage

Realignment due to locational arbitrage

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

are based on the amount of
money used and the size of the discrepancy.

drives prices to adjust in different locations so as to eliminate discrepancies.

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Triangular Arbitrage

Defined

to capitalize on discrepancies in the cross exchange rates between two currencies.

Gains from triangular arbitrage

Currency transactions are conducted in the spot market to capitalize on the discrepancy in the cross exchange rate between two countries.

Accounting for the Bid/Ask Spread

Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage

Realignment due to triangular arbitrage

forces exchange rates back into equilibrium

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Covered Interest Arbitrage

Defined

Consists of two parts

Realignment due to covered interest arbitrage

Timing of realignment

Realignment is focused on the forward rate

Accounting for spreads

Covered interest arbitrage by Non-U.S. investors

as the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract.

Interest arbitrage:

Covered

process of capitalizing on the difference between interest rates between two countries.

hedging the position against interest rate risk.

causes market
realignment

may require several transactions before
realignment is completed.

forward rate is likely to experience most if not all of the adjustment needed to achieve realignment.

Investor must account for the effects of the spread between the bid and ask quotes and of the spread between deposit and loan rates.

applies to any two countries for which there is a spot rate and a forward rate between their currencies as well as risk-free interest rates quoted for both currencies.

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The threat of locational arbitrage

Comparison of Arbitrage Effects

The threat of triangular arbitrage

The threat of covered interest arbitrage

How arbitrage reduces transaction costs

ensures that quoted
exchange rates are similar across banks in different locations.

ensures that cross exchange
rates are properly set.

ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy.

arbitrage tends to allow for a more orderly foreign
exchange market.

Locational arbitrage

limits the differences in a spot exchange
rate quotation across locations

covered interest arbitrage

ensures that the forward rate is properly priced. Thus, an MNC’s managers should be able to avoid excessive transaction costs.

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Interest Rate Parity

In equilibrium

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

Derivation of Interest Rate Parity

Determining the Forward Premium

Effect of the interest rate differential

relationship between the forward premium (or discount) and the interest rate differential according to IRP

Implications

If the forward premium is equal to the interest rate differential as just described, then covered interest arbitrage will not be feasible

Graphic Analysis of Interest Rate Parity

Points representing a discount: points A and B

Points representing a premium: points C and D

Points representing IRP: points A, B, C, D

Points below the IRP line: points X and Y

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

Points above the IRP line: point Z

U.S. investors would achieve a lower return on a foreign investment than on a domestic one.

Test Whether Interest Rate Parity Holds

location of the points

points to the right of the IRP line

investors and firms take advantage

Covered interest arbitrage

provides an indication of
whether covered interest arbitrage is worthwhile.

investors in the home country should consider using covered interest arbitrage, since a return higher than the home interest rate (ih ) is achievable.

of such opportunities, the point will tend to move toward the IRP line.

should continue until the
interest rate parity relationship holds.

Interpretation of Interest Rate Parity

Interest rate parity does not imply that investors from
different countries will earn the same returns.

Does Interest Rate Parity Hold

Compare the forward rate (or discount) with interest rate quotations occurring at the same time. Due to limitations in access to data

Considerations When Assessing Interest Rate Parity

Transaction costs

Political risk

 Differential tax laws