Madura: International Financial Management Chapter 7

Chapter Objectives
Chapter
7
International Arbitrage And „ To explain the conditions that will
Interest Rate Parity result in various forms of international
arbitrage, along with the realignments that
will occur in response; and
„ To explain the concept of interest rate
parity, and how it prevents arbitrage
opportunities.

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International Arbitrage International Arbitrage

• Arbitrage can be loosely defined as • As applied to foreign exchange and

capitalizing on a discrepancy in quoted international money markets, arbitrage
prices to make a riskless profit. takes three common forms:
• The effect of arbitrage on demand and ¤ locational arbitrage
supply is to cause prices to realign, such ¤ triangular arbitrage
that no further risk-free profits can be
¤ covered interest arbitrage
made.

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Madura: International Financial Management Chapter 7

Locational Arbitrage Triangular Arbitrage

• Locational arbitrage is possible when a • Triangular arbitrage is possible when a
bank’s buying price (bid price) is higher cross exchange rate quote differs from the
than another bank’s selling price (ask rate calculated from spot rate quotes.
price) for the same currency. Example Bid Ask
British pound (£) $1.60 $1.61
Example Malaysian ringgit (MYR) $.200 $.202
Bank C Bid Ask Bank D Bid Ask British pound (£) MYR8.10 MYR8.20
NZ$ $.635 $.640 NZ$ $.645 $.650 MYR8.10/£ × $.200/MYR = $1.62/£
Buy NZ$ from Bank C @ $.640, and sell it to Buy £ @ $1.61, convert @ MYR8.10/£, then
Bank D @ $.645. Profit = $.005/NZ$. sell MYR @ $.200. Profit = $.01/£.

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Triangular Arbitrage Covered Interest Arbitrage

US$ • Covered interest arbitrage is the process
Value of Value of
£ in $ MYR in $
of capitalizing on the interest rate
differential between two countries while
£ MYR covering for exchange rate risk.
Value of
£ in MYR • Covered interest arbitrage tends to force a
relationship between forward rate
• When the actual and calculated cross premiums and interest rate differentials.
exchange rates differ, triangular arbitrage
will force them back into equilibrium.

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Madura: International Financial Management Chapter 7

Covered Interest Arbitrage Comparing Arbitrage Strategies

Example
Locational : Capitalizes on discrepancies in
£ spot rate = 90-day forward rate = $1.60 Arbitrage exchange rates across locations.
U.S. 90-day interest rate = 2%
U.K. 90-day interest rate = 4% $/£ quote $/£ quote
Borrow $ at 3%, or use existing funds which by Bank X by Bank Y
are earning interest at 2%. Convert $ to £ at
$1.60/£ and engage in a 90-day forward
contract to sell £ at $1.60/£. Lend £ at 4%.
Note: Profits are not achieved instantaneously.
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Comparing Arbitrage Strategies Comparing Arbitrage Strategies

Triangular : Capitalizes on discrepancies in Covered Capitalizes on discrepancies

Arbitrage cross exchange rates. Interest : between the forward rate and the
Arbitrage interest rate differential.
€/£ quote
by Bank A Differential
Forward rate
of £ quoted in between U.S.
dollars and British
interest rates
$/£ quote $/€ quote
by Bank B by Bank C

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Madura: International Financial Management Chapter 7

Comparing Arbitrage Strategies Interest Rate Parity (IRP)

• As a result of market forces, the forward
• Any discrepancy will trigger arbitrage,
rate differs from the spot rate by an
which will then eliminate the discrepancy,
amount that sufficiently offsets the
thus making the foreign exchange market
interest rate differential between two
more orderly.
currencies.
• Then, covered interest arbitrage is no
longer feasible, and the equilibrium state
achieved is referred to as interest rate
parity (IRP).

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Derivation of IRP Derivation of IRP

• When IRP exists, the rate of return • End-value of a $1 investment in the home
achieved from covered interest arbitrage country = 1 + iH
should equal the rate of return available in
the home country. • Equating the two and rearranging terms:
• End-value of a $1 investment in covered p = (1+iH) – 1
interest arbitrage = (1/S)× (1+iF)× F (1+iF)
= (1/S)× (1+iF)× [S×(1+p)] i.e.
= (1+iF)× (1+p)
where p is the forward premium. forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)
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Madura: International Financial Management Chapter 7

Determining the Forward Premium Determining the Forward Premium

Example • The IRP relationship can be rewritten as
• Suppose 6-month ipeso = 6%, i$ = 5%. follows:
• From the U.S. investor’s perspective, F – S = S(1+p) – S = p = (1+iH) – 1 = (iH–iF)
forward premium = 1.05/1.06 – 1 ≈ -.0094 S S (1+iF) (1+iF)
• If S = $.10/peso, then • The approximated form, p ≈ iH – iF,
6-month forward rate = S × (1 + p) provides a reasonable estimate when the
_
≈ .10 × (1 .0094) interest rate differential is small.
≈ $.09906/peso

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Graphic Analysis of Interest Rate Parity Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%) Interest Rate Differential (%)
home interest rate – foreign interest rate home interest rate – foreign interest rate
4 4
Zone of potential
IRP line covered interest IRP line
Z arbitrage by
2 foreign investors 2
B X

Forward -3 -1 1 3 Forward Forward -3 -1 1 3 Forward

Discount (%) Premium (%) Discount (%) Premium (%)
Y Zone of potential
A -2 -2 covered interest
arbitrage by
W local investors
-4 -4
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Madura: International Financial Management Chapter 7

Test for the Existence of IRP Interpretation of IRP

• To test whether IRP exists, collect actual
interest rate differentials and forward
premiums for various currencies, and plot
them on a graph.
• IRP holds when covered interest arbitrage
is not possible or worthwhile.
• 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.

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Does IRP Hold?

Forward Rate Does IRP Hold?
Premiums and
Interest Rate • Various empirical studies indicate that IRP
Differentials for generally holds.
Seven Currencies
• While there are deviations from IRP, they
are often not large enough to make
covered interest arbitrage worthwhile.
• This is due to the characteristics of
foreign investments, such as transaction
costs, political risk, and differential tax
laws.

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Madura: International Financial Management Chapter 7

Considerations When Assessing IRP Considerations When Assessing IRP

Transaction Costs Political Risk
iH – iF ¤ A crisis in a country could cause its
IRP line government to restrict any exchange of the
Zone of potential
covered interest local currency for other currencies.
arbitrage by
foreign investors Zone of ¤ Investors may also perceive a higher
p potential
covered default risk on foreign investments.
Zone where
covered interest interest
arbitrage is not arbitrage Differential Tax Laws
feasible due to by local ¤ If tax laws vary, after-tax returns should be
transaction costs investors
considered instead of before-tax returns.

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Annualized interest rate

8%
8%

6%
Changes in Forward Premiums
6%

4%
4%
i€ Euro’s interest rate
2%
2%
i$
U.S. interest rate
0%
0%
Q3 Q1 Q3 Q1 Q3 Q1 Q3
Q1
i Q3
> i€ Q1
2%2000 $ 2001
Q3 Q1
2002
Q3 Q1 Q3
2003
Q1
i$ – i€

i$ = i€
0%
i$ < i€
-2%
Q3 Q1 Q3 Q1 Q3 Q1 Q3
Forward premium of €

premium
2%2000 2001 2002 2003

0%
discount
-2%
Q3 Q1 Q3 Q1 Q3 Q1 Q3
2000 2001 2002 2003 7 - 27

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