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

2. 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.

3. 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.

4. 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

5. 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.

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

7. Triangular arbitrage

8. Exchange rates 08. February 2002

9. 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 $
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.

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

11. Interest Rate Parity

12. Interest Rate Parity

13. 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

14. 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

15. 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.

16. 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.

17. Unbiased forward rate

18. 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

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

20. 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