Download presentation
Presentation is loading. Please wait.
1
International Arbitrage
Chapter 11 International Arbitrage
2
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
3
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
4
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
5
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
6
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
7
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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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
18
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
19
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
20
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
21
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
22
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
23
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
24
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
25
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
26
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
27
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
28
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
Similar presentations
