International Financial Management

ASSIGNMENT ON
INTERNATIONAL ARBITRAGE
AND
COVERED INTEREST RATE ARBITRAGE

Submitted to: Submitted By:

Prof. Deepak Tandon Vaibhav Sahu (113/09)

International Arbitrage & Covered Interest Arbitrage 1

ARBITRAGE

Aarbitrage is the practice of taking advantage of a price difference between

two or more markets: striking a combination of matching deals that capitalize
upon the imbalance, the profit being the difference between the market prices.
In academic use, an arbitrage involves taking advantage of differences in price
of a single asset or identical cash-flows.

CONDITIONS FOR ARBITRAGE

Arbitrage is possible when one of three conditions is met:

1. The same asset does not trade at the same price on all markets/
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its
future price discounted at the risk-free interest rate.

TYPES OF ARBITRAGES

1. International arbitrage
2. Currency Arbitrage
3. Covered Interest Arbitrage
4. Uncovered Interest Arbitrage
5. Merger Arbitrage
6. Option Arbitrage
7. Equity Arbitrage
8. Stock Arbitrage
9. Fixed income Arbitrage etc.

International Arbitrage & Covered Interest Arbitrage 2

INTERNATIONAL ARBITRAGE
The practice of buying and selling a security registered in a foreign country and
an International Depositary Receipt based on that same security. This allows
the arbitrageur to profit from inefficiencies in price resulting from the exchange
rate, the difference in price on different exchanges, and other factors.

International arbitrage revolves around taking advantages of price differences

between goods and securities in different countries. While this is a common
practice among many types of investors, arbitrage separates itself because the
buying and selling happen nearly simultaneously. When the broker is
purchasing an item in one market, they are selling that same item in a different
market. International arbitrage is widely seen as a little to no-risk investment,
as the initial purchase doesn’t take place unless the profit is available right
then.

This investment method relies on multiple markets in vastly different locations.

Even though most investment markets are tied together by computer, that
doesn’t stop small discrepancies from popping up in the system. High turnover
goods, like monetary investments, will often have small surges in one area, but
not in others. This surge will translate through the system, but it will often
create a small bubble in the original market. This bubble will cause the good to
have a higher or lower value than elsewhere.

International arbitrage follows a fairly simple process, but what it lacks in

complexity it makes up for in timing. In a typical arbitrage situation, the
investor is monitoring one good on multiple markets. When they see that a
specific stock, commodity or monetary bond is selling at a different rate in one
market, they purchase it at the lower price. The investor then turns to the
market where it is selling higher and sells it. The difference in the two markets
is pure profit.

Since international arbitrage relies on the buying and selling at nearly the same
time, this process has increased as computers and technology allow for instant

International Arbitrage & Covered Interest Arbitrage 3

communication. When an investor sees the market imbalance, they need to act
immediately before it closes. This requires a nearly instant purchase and sale,
something that was impossible before the communication systems became
global.

While international arbitrage seems like a no-fail type of investing, there is a

small element of risk. The entire system centres on the speed of
communication between the buyer and seller. If any part of the communication
chain falters or lags, then the seller may not capitalize on the proper price.
Since market imbalances are often very short-lived, even a few seconds could
disrupt the sale.

COVERED INTEREST ARBITRAGE

Covered interest arbitrage is the investment strategy where an investor buys
a financial instrument denominated in a foreign currency, and hedges his
foreign exchange risk by selling a forward contract in the amount of the
proceeds of the investment back into his base currency.

International Arbitrage & Covered Interest Arbitrage 4

Currency arbitrage carried out by purchasing financial instruments in different
currencies and using a Forward Exchange Contract to lock in a yield. The trade
makes use of inconsistencies between interest rates and forward rates to make a
risk-less profit.
CIA is the movement of short term funds between countries to take advantage
of interest differentials with the exchange risk covered by the forward
contracts. When investors purchase the currency of a foreign country to take
advantage of the higher interest rates abroad, they must also consider any
losses or gains. Such gains or losses might occur due to fluctuations in the value
of the foreign currency prior to the maturity of their investment. Generally, the
investors cover against such partial losses by contracting for the future sale or
purchase of a foreign currency in the forward market.

REASONS FOR CIA

There is the difference between the interest rate of the different countries at
any given point of time. This difference occur due to differences in phases of
growth of economies, political situation, geographical location, strategic
position, human resource development and various such factors. The strategy
of Covered Interest Arbitrage exist as an exploitation of the International
Fischer Equation and Interest Rate parity between any two countries while
covering the risk using the instrument of forward or future contract. While the
forward rate and spot rate fluctuations occur due to fluctuations in demand
and supply of a particular currency against the foreign currency, the changes in
interest rate occur due to changes in borrowing and investments preferences of
the investors in different countries. These fluctuations result in the arbitrage
opportunity being done for a very limited period after which interest rates and
the exchange rates adjust to nullify the effect.

EXAMPLE

International Arbitrage & Covered Interest Arbitrage 5

In this example the investor is based in the United States and assumes the
following prices and rates: Spot USD/EUR = $1.2000, Forward USD/EUR for 1
year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.

• Exchange USD 1,200,000 into EUR 1,000,000

• Buy EUR 1,000,000 worth of euro-denominated bonds
• Sell EUR 1,025,000 via a 1 year forward contract, to receive USD
1,260,750, i.e. agree to exchange the euros back into US dollars in 1 year
at today's forward price.
• At the expiry of one year, two transactions occur consecutively. First, the
euro-denominated bond delivers EUR 1,025,000. Secondly, the forward
contract turns the EUR 1,025,000 into USD 1,260,750. So, the earning is
USD 60,750. Had the investment been made in dollar, the return would
have been only 4%. But, in this case, the two transactions can be viewed
as resulting in an effective dollar interest rate of (1,260,750/1,200,000)-1 =
5.1%
• The above discussion does not consider the cost of capital. Alternatively,
if the USD 1,200,000 were borrowed at 4%, USD 1,248,000 would be
owed in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD
12,750 in 1 year.

The strategy of Covered Interest Arbitrage exist as an

exploitation of the International Fischer Equation and
Interest Rate parity between any two countries while
covering the risk using the instrument of forward or future
contract.

International Arbitrage & Covered Interest Arbitrage 6

INTERNATIONAL FISCHER EQUATION
The relationship between the foreign exchange market and the money markets
is established by the International Fischer Equation. The difference in the
national interest rates for securities of similar risk and maturity should be equal
to, but opposite in sign to, the forwards rates discount or premium for the
foreign currency. In other words, the returns from borrowing in one currency,
exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures
contracts to convert the currency back at the end of the holding period, should
be equal to the returns from purchasing and holding similar interest-bearing
instruments of the first currency. Thus, any gain or loss incurred by the
investor in simultaneous transaction in spot and forward market is offset by
interest rate differential in two countries.
Thus, for International Fischer equation to be true, both the actions should
lead to the same return at all points of time.

Mathematically, the International Fischer Equation is established as:

Where i$ = interest rate in foreign country

F= forward rate
S= Spot rate
ic = Interest rate in home country.
The RHS of this equation should balance the LHS of the equation generally.
Whenever there is fluctuation on one side, the other changes to compensate for
the change and thus balance the equation.
Example:
US interest rate= 5%
UK interest rate = 4%

International Arbitrage & Covered Interest Arbitrage 7

Spot Rate = 0.50 GBP/USD
Forwards Rate = 0.504 GBP/USD
The investor has two options
Option 1: To invest money in US market @5% to earn 105 at the end of the year
Option 2: To convert 100 USD into GBP (200GBP) and invest in UK market @
4% to earn 216 GBP after an year and then convert it into USD at the forward
rate of 0.504GBP/USD. He will get 105 USD.
Thus, both the options avail him similar return.

LHS = (1+rh)
RHS =F/S *(1+rf)
When LHS is not = RHS à Arbitrage exists
• If LHS <RHS --One would borrow home currency, convert receipts to
foreign currency at spot rate, invest in for. Currency denominated
securities 9as Foreign Securities carry higher Interest). At the same time
he will cover his principal and interest from this investment at the
forward rate. At maturity, he would convert the proceeds of the foreign
investment at a prefixed forward rate and payoff the domestic liability.
The difference between the receipts and payments serve as profit to the
customer.

• If LHS > RHS ,One would borrow , foreign currency, convert receipts to
domestic currency at a prevailing rate ( Spot ), invest in domestic
currency denominated securities (as domestic securities carry higher
interest). At the same time he would cover his principal and interest
from this investment at the forward rate. At maturity, he would convert
the proceeds of the domestic investment at the prefixed domestic
forward rate and payoff the foreign liability. The difference between
receipts and payments serve as profit to customer.

International Arbitrage & Covered Interest Arbitrage 8

INTEREST RATE PARITY

Interest rate parity is a non-arbitrage condition which says that the returns
from borrowing in one currency, exchanging that currency for another currency
and investing in interest-bearing instruments of the second currency, while
simultaneously purchasing futures contracts to convert the currency back at
the end of the holding period, should be equal to the returns from purchasing
and holding similar interest-bearing instruments of the first currency. If the
returns are different, an arbitrage transaction could, in theory, produce a risk-
free return.

Looked at differently, interest rate parity says that the spot price and the
forward, or futures price, of a currency incorporate any interest rate
differentials between the two currencies assuming there are no transaction
costs or taxes.

When IRP exist, the rate of return achieved from CIA should equal the rate of
return available in home country.

International Arbitrage & Covered Interest Arbitrage 9

Going back to International Fischer Equation,

RHS = [{SX(1+p)}/S] * (1+ic)

= (1+ic) * (1+p)
Where p = forward premium
From IFE, we can say that
p= [(1+i$)/(1+ic)] - 1
= [(i$- ic)/(1+ic)]
In approximated form, p = i$- ic, provides a reasonable estimate when the
interest rate differential is small.
It is clear that Interest Rate Parity hold when the Covered Interest Arbitrage
does not exist. Also, when Interest Rate Parity exists, it does not mean that
both local and foreign investors will earn the same returns. It simple means
that investors cannot use covered interest arbitrage to achieve higher returns
than those achievable in their respective home countries.
The deviations from Interest Rate Parity occur due to characteristics of foreign
investments, such as transaction costs, political risk and differential tax laws.
For example, interest rate in US is low because it’s the safest and developed
economy in the world. Apart from that, the government is stable, follows
Capitalistic form of governance and has agreeable trade allowances, has good
human resource development, has feasible investment options and is a hub for
new technological advancements with many world organizations
headquartered in its major cities.
In contrast to that, Afghanistan has high interest rate because of the unstable
government, weak economy, bad human resource development, higher
prospect of terrorist attacks and killings, poor technological advancement,
discourages foreign investments. These factors increase the riskiness of the
investment who therefore seeks higher returns.

International Arbitrage & Covered Interest Arbitrage 10

ARBITRAGE CORRECTION

Arbitrage opportunity does not remain available for a long period. Market
forces correct to make a balance (Fischer Equation).
If RHS>LHS, following changes will happen:

1. Interest rates of domestic country will rise

2. Interest rates of foreign currency will fall
3. Spot rate will become high
4. Forward rate will fall.

CONCLUSION
• The International Fischer equation explains why investments across the
world are balanced.
• The differences in interest rate of different countries occur to capture
the risk profile of different economies.
• If there are changes in the interest rates in one country, other countries
are also bound to make a change in their interest rates to avoid huge
demand for one particular currency.
• Covered Interest Arbitrage is the exploitation of the IRP and is used and
can be used by the investors only for the short term investments.

International Arbitrage & Covered Interest Arbitrage 11