International Arbitrage and Interest Rate Parity CHAPTER 7 International Arbitrage and Interest Rate Parity © 2000 South-Western College Publishing 1

Chapter Objectives To explain the conditions that will result in various forms of international arbitrage, along with the realignments that will occur in response to the various forms of international arbitrage; and To explain the concept of interest rate parity, and how it prevents arbitrage opportunities.

International Arbitrage Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. Often, the funds invested are not tied up and no risk is involved. Locational arbitrage is possible when the bid price of one bank is higher than the ask price of another bank for the same currency. In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly.

Locational arbitrage $1.78 $1.76 Sells pound for $1.77 $1.75 Buys pound for Market B Market A The Bank Buy pound for $1.76 pr. £ in market A and sell pound for $1.77 pr. £ in market B. Short term profit until equilibrium is restored may be possible

Triangular arbitrage Currency cross rates - ”calculated exchange rates” Assume 1 £ is worth $ 1.60 and 1 C$ is worth $ 0.80 Cross rate £/C$ = 1.60/0.80 = 2.00 Triangular arbitrage is possible when a quoted cross exchange rate differs from that calculated using the appropriate spot rates.

Triangular arbitrage Assume you have the following 1 000 000 $ to play with Westminster Bank: $ 1.5500/£ Shanghai Bank € 1.5000/£ Wells Fargo $ 1.0600/€ Is triangular arbitrage possible ? Cross rate $/€ = 1.55/1.50 = 1.0333 Sell $ where it`s expensive, buy it back where it`s cheap

Triangular arbitrage

Exchange rates 08. February 2002

International Arbitrage Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate. Assume you have $ 800 000 Spot rate is $ 1.60/£, 90 day forward $ 1.60/£ 90 day interest rate in US and UK: 2 % and 4 % In response to the imbalance in demand and supply resulting from such arbitrage activity, the rates will adjust very quickly.

Covered Interest Arbitrage Assume you have 1 000 000 USD for 90 d Swiss franc interest rate 4.00% p.a. US $ interest rate 8.00 % p.a. Spot rate = 1.4800 CHF/$, 90 day forward = 1.4655 CHF/$ Is arbitrage possible ?

Interest Rate Parity

Interest Rate Parity

Graphic Analysis of Interest Rate Parity Interest Rate Differential (%) home interest rate - foreign interest rate Forward Premium (%) Discount (%) - 2 - 4 2 4 1 3 - 1 - 3 IRP line

Graphic Analysis of Interest Rate Parity Home Interest Rate - Foreign Interest Rate (%) Forward Premium (%) Discount (%) - 2 - 4 2 4 1 3 - 3 - 1 IRP line Zone of potential covered interest arbitrage by foreign investors Zone of potential covered interest arbitrage by local investors Zone where covered interest arbitrage is not feasible

Interest Rate Parity IRP generally holds. Where it does not hold, covered interest arbitrage may still not be worthwhile due to transaction costs, currency restrictions, differential tax laws, political risk, etc. 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.

Correlation Between Spot and Forward Rates Interest Rates iA iU.S. time Forward Rates Spot and SpotA ForwardA. Because of interest rate parity, a forward rate will normally move in tandem with the spot rate. This correlation depends on interest rate movements.

Unbiased forward rate

Impact of Arbitrage on an MNC’s Value Forces of Arbitrage E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent

Chapter Review International Arbitrage Locational Arbitrage Triangular Arbitrage Covered Interest Arbitrage Comparison of Arbitrage Effects

Chapter Review Interest Rate Parity Derivation of Interest Rate Parity Numerical Example Graphic Analysis of Interest Rate Parity Interpretation of Interest Rate Parity Considerations When Assessing Interest Rate Parity Correlation Between Spot and Forward Rates Impact of Arbitrage on an MNC’s Value