International Arbitrage Chapter 11 International Arbitrage

Slides prepared by Afaf Moosa Objectives To define arbitrage and the no-arbitrage condition To describe two-point, three-point and multi-point arbitrage in the foreign exchange market To describe commodity arbitrage (cont.) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Objectives (cont.) To describe covered interest arbitrage and show how the no-arbitrage condition can be used to determine the forward exchange rate To describe uncovered arbitrage and introduce the concept of carry trade Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Definition of arbitrage Arbitrage is generally defined as capitalising on a discrepancy in quoted prices as a result of the violation of an equilibrium (no-arbitrage) condition The arbitrage process restores equilibrium via changes in the supply of and demand for the underlying commodity, asset or currency (cont.) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Definition of arbitrage (cont.) The importance of arbitrage is that no-arbitrage conditions are used for asset pricing, such that the equilibrium price of a financial asset is the price that is consistent with the underlying no-arbitrage condition Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Two-point arbitrage Also known as spatial or locational arbitrage, it arises when the following condition is violated: Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Two-point arbitrage with bid-offer spreads With bid-offer spreads the no-arbitrage condition becomes: Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Three-point (triangular) arbitrage It is triggered when cross exchange rates are inconsistent, that is, when the following condition is violated: Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Profitable/unprofitable sequences x z y (a) Unprofitable sequence z x y (b) Profitable sequence Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Multipoint arbitrage The condition precluding multipoint arbitrage is: Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Five-point arbitrage AUD USD EUR GBP JPY Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Commodity arbitrage The no-arbitrage condition in the case of commodity arbitrage is the law of one price (LOP): (cont.) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Commodity arbitrage (cont.) Commodity arbitrage is conducted by buying a commodity in a market where it is cheap and selling it in a market where it is more expensive Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Covered interest arbitrage Covered interest arbitrage is triggered by the violation of the covered interest parity (CIP) condition, which describes the equilibrium relation between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Return on Investments Converting at spot rate Investing in foreign assets Reconverting at forward rate Domestic investment Foreign Investor (K) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The CIP equilibrium condition Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Covered interest arbitrage Covered margin Investing at domestic rate Domestic  foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign  domestic Borrowing foreign currency S 1 unit Reconverting at forward rate Loan repayment Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Profit from covered arbitrage (domestic→foreign) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

The interest parity forward rate Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Covered arbitrage with bid-offer spreads (domestic→foreign) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Covered arbitrage with bid-offer spreads (foreign→domestic) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Arbitrage with bid-offer spreads Covered margin Investing at domestic bid rate Domestic  foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign  domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at forward bid rate Loan repayment Reconverting at forward offer rate Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Uncovered interest arbitrage Uncovered arbitrage is triggered by the violation of the uncovered interest parity (UIP) condition. It is described as ‘uncovered’ because, unlike covered arbitrage, the long currency position is not covered in the forward market but rather left uncovered or open Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Carry trade Carry trade is a kind of uncovered interest arbitrage in which a short position is taken on a low-interest currency and a long position is taken on a high-interest currency Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa Return on domestic investment and foreign investment (with uncovered position) Converting at spot rate Investing in foreign assets Reconverting at expected spot rate Domestic Investment Foreign Investor (K) Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Slides prepared by Afaf Moosa The UIP condition Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Uncovered interest arbitrage Covered margin Investing at domestic rate Domestic  foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign  domestic Borrowing foreign currency S 1 unit Reconverting at spot rate Loan repayment Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa

Uncovered arbitrage with bid-offer spreads Covered margin Investing at domestic bid rate Domestic  foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign  domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at spot bid rate Loan repayment Reconverting at spot offer rate Copyright  2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa