CHAPTER 4

INTERNATIONAL ARBITRAGE AND

INTEREST RATE PARITY
CHAPTER OBJECTIVES

Explain the conditions that will result in various forms

of international arbitrage and the realignments that will
occur in response
Explain the concept of interest rate parity
 WHAT IS ARBITRAGE?

FARMER SHOP CENTER SHOP

WHAT IF YOU CAN BUY APPLES AT THE LOWER PRICE AND SELL THEM AT THE
HIGHER PRICE? IS IT AN ATTRACTIVE IDEA FOR MAKING MONEY?
ANOTHER EXAMPLE OF ARBITRAGE
EXAMPLE: Two coin shops buy and sell coins. If
Shop A is willing to sell a particular coin for $120,
while Shop B is willing to buy that same coin for $130,
a person can execute arbitrage by purchasing the coin at
Shop A for $120 and selling it to Shop B for $130. The
prices at coin shops can vary because demand
conditions may vary among shop locations.
If two coin shops are not aware of each other’s prices,
the opportunity for arbitrage may occur.
 WILL PRICES BE THE SAME AFTER THE
ARBITRAGE?
The act of arbitrage will cause
prices to realign.
In our example, arbitrage would
cause FARMER SHOP to raise its
selling price (due to high demand for
its product). At the same time,
CENTER SHOP would reduce its
buying price after receiving a surplus Quantity Quantity
of apples as arbitrage occurs.
A- INTERNATIONAL ARBITRAGE
1. Capitalizing on
discrepancies of quoted [Link] risk-free profit
prices

3. No tied up investment 4. Causing the realignment

funds for some types of quoted prices

Taking the opportunity from imperfections of market

A- INTERNATIONAL ARBITRAGE
The type of arbitrage discussed in this chapter is primarily
international in scope; it is applied to foreign exchange and
international money markets and takes three common forms:
➢ Locational arbitrage
➢ Triangular arbitrage
➢ Covered interest arbitrage
A.1 LOCATIONAL ARBITRAGE
NORTH BANK SOUTH BANK
BID ASK BID ASK
British pound British pound
$1.59 $1.60 $1.61 $1.62
quote quote

You could conduct locational arbitrage by purchasing pounds at North

Bank for $1.60 per pound and then selling them at South Bank for $1.61
per pound.
How much of profit per pound you will end up with?
1. LOCATIONAL ARBITRAGE
a. Definition
When quoted exchange rates vary among locations, participants
in the foreign exchange market can capitalize on the discrepancy.
Specifically, they can use locational arbitrage, which is the
process of buying a currency at the location where it is priced
cheap and immediately selling it at another location where it
is priced higher.
1. LOCATIONAL ARBITRAGE
b. Gains from locational arbitrage
NORTH BANK SOUTH BANK
BID ASK BID ASK
British pound British pound
$1.59 $1.61 $1.61 $1.62
quote quote

To achieve profits from locational arbitrage, the bid price of

one bank must be higher than the ask price of another bank
 PRACTICE 1
Suppose two banks have the following bid-ask FX quotes: GBP/USD
Bank A 1.50 - 51
Bank B 1.53 - 55
Explain the locational arbitrage.
How much will you gain from the arbitrage if you start with
$10,000?
IMPACT OF LOCATIONAL ARBITRAGE

Ask price A
Demand of
GBP at Bank A Suppy of GBP at
Bank B
Bid price B
[Link] ARBITRAGE
• Cross exchange rates represent the relationship between two
currencies that are different from one’s base currency.
Example: If the British pound (£) is worth $1.60, while the Canadian dollar
(C$) is worth $.80, the value of the British pound with respect to the
Canadian dollar is calculated as follows:
Value of £ in units of C$ = $1.60/$.80 = 2.0
The value of the Canadian dollar in units of pounds can also be determined
from the cross exchange rate formula:
Value of C$ in units of £ = $.80/$1.60 = .50
2. TRIANGULAR ARBITRAGE

• If a quoted cross exchange rate differs from the appropriate

cross exchange rate (as determined by the formula), you can
attempt to capitalize on the discrepancy.
• Specifically, you can use triangular arbitrage in which currency
transactions are conducted in the spot market to capitalize on a
discrepancy in the cross exchange rate between two currencies.
EXAMPLE 1: SIMPLE QUOTED PRICE

Quoted
Price
GBP/USD 1.60

MYR/USD 0.200

GBP/MYR 8.10
EXAMPLE:TRIANGULAR ARBITRAGE
➢The cross exchange rate that should exist between the pound
and the Malaysian ringgit: the pound should be worth
MYR8.0.
➢Based on this information, you can engage in triangular
arbitrage by purchasing pounds with dollars, converting the
pounds to ringgit, and then exchanging the ringgit for dollars
EXAMPLE 1: STEPS INVOLVED
 EXAMPLE 2: ACCOUNTING FOR BID/ASK

Quoted Quoted
Bid Price Ask Price
GBP/USD 1.60 1.61

MYR/USD 0.200 0.201

GBP/MYR 8.10 8.20

How do you conduct the arbitrage if you have $10,000 to invest?

 EXAMPLE 2: STEPS INVOLVED
Step 1. Your initial $10,000 will be converted into approximately £6,211
(based on the bank’s ask price of $1.61 per pound).
Step 2. Then the £6,211 are converted into MYR50,310 (based on the bank’s
bid price for pounds of MYR8.1 per pound, £6,211 × 8.1 = MYR50,310).
Step 3. The MYR50,310 are converted to $10,062 (based on the bank’s bid
price of $.200).
The profit is $10,062 – $10,000 = $62. The profit is lower here than in the
previous example because bid and ask quotations are used.
 EXAMPLE 2: STEPS INVOLVED
Step 1. Your initial $10,000 will be converted into approximately £6,211
(based on the bank’s ask price of $1.61 per pound).
Step 2. Then the £6,211 are converted into MYR50,310 (based on the bank’s
bid price for pounds of MYR8.1 per pound, £6,211 × 8.1 = MYR50,310).
Step 3. The MYR50,310 are converted to $10,062 (based on the bank’s bid
price of $.200).
The profit is $10,062 – $10,000 = $62. The profit is lower here than in the
previous example because bid and ask quotations are used.
IMPACT OF TRIANGULAR ARBITRAGE
ACTIVITY IMPACT
1. Participants use dollars to purchase Bank increases its ask price of
pounds. pounds with respect to the dollar.

2. Participants use pounds to purchase Bank reduces its bid price of the
Malaysian ringgit. British pound with respect to the
ringgit; that is, it reduces the number
of ringgit to be exchanged per pound
received.

3. Participants use Malaysian ringgit to Bank reduces its bid price of ringgit
purchase U.S. dollars. with respect to the dollar
 QUICK CATCH-UP
1. Demand of a currency a. More people to sell
increases when: b. Equilibrium at one time to convert
2. Supply of a currency one currency into another
increases when: c. More people to buy
3. Forward rate d. Price to buy/sell foreign currency at
4. Spot rate specified rate in the future time

⍰ One man considers to invest in financial securities, in which situation he may

want to invest in foreign securities:
a. If the interest rate in his home country is higher than interest rate in a foreign country
b. If the interest rate in his home country is lower than interest rate in a foreign country
PREMIUM OR DISCOUNT ON
FORWARD RATE
Type of exchange
F = S(1 + p) Value
rate of GBP/USD
Where:
Spot rate $1.681
F is the forward rate
S is the spot rate 30-day Forward
$1.680
p is the forward premium or rate
forward discount 90-day Forward
$1.672
rate
THE STEPS INVOLVED:
Based on this information, you should proceed as follows:
1. On day 1, convert the $800,000 to £500,000 and deposit the £500,000 in a British
bank.
2. On day 1, sell £520,000 90 days forward. By the time the deposit matures, you will
have £520,000 (including interest).
3. In 90 days when the deposit matures, you can fulfill your forward contract obligation
by converting your £520,000 into $832,000 (based on the forward contract rate of $1.60
per pound).
The strategy results in a 4 percent return over the 3-month period, which is 2 percent
above the return on a U.S. deposit. In addition, the return on this strategy is known on day
1, since you know when you make the deposit exactly how many dollars you will get
back from your 90-day investment.
[Link] COMPARISON OF ARBITRAGE EFFECTS
International arbitrage eliminates any discrepancies in
foreign exchange market.
Locational Triangular Covered interest
arbitrage arbitrage arbitrage

• Exchange rates
of two
• Cross exchange • The forward
currencies are
rates are exchange rates
similar across
properly set are properly set
different
locations
 3. COVERED
INTEREST
ARBITRAGE

⍰ One man considers to invest in financial securities, in which situation he may

want to invest in foreign securities:
a. If the interest rate in his home country is higher than interest rate in a foreign country
b. If the interest rate in his home country is lower than interest rate in a foreign country
3. COVERED INTEREST ARBITRAGE

• Covered interest arbitrage is the process of capitalizing on

the interest rate differential between two countries while
covering your exchange rate risk with a forward contract.
• The logic of the term covered interest arbitrage becomes clear
when it is broken into two parts: “interest arbitrage” refers to the
process of capitalizing on the difference between interest rates
between two countries; “covered” refers to hedging your
position against exchange rate risk
3. COVERED INTEREST ARBITRAGE
Assume the following information:
• You have $800,000 to invest.
• The current spot rate of the pound is $1.60.
• The 90-day forward rate of the pound is $1.60.
• The 90-day interest rate in the United States is 2 percent.
• The 90-day interest rate in the United Kingdom is 4 percent.
HOW TO CONDUCT THE ARBITRAGE
REALIGNMENT DUE TO CIA
a. Forward rate: there is downward pressure on the 90-day
forward rate.
• When forward rate has a discount from the spot rate that is
equal to interest rate advantage, the arbitrage is no longer
feasible
b. Spot rate: could experience the upward pressure, but since
forward market is less liquid, the forward rate is more sensitive to
shifts in demand or supply conditions caused by CIA.
 REALIGNMENT DUE TO ARBITRAGE
Assume that as a result of covered interest arbitrage, the 90-day
forward rate of the pound declined to $1.5692. Consider the
results from using $800,000 (as in the previous example) to
engage in covered interest arbitrage after the forward rate has
adjusted.
How much gains to investors from CIA now?
The return from covered interest arbitrage can be no better than
what you can earn domestically.
1. INTEREST RATE PARITY
Consider a U.S. investor who attempts covered interest arbitrage.
• The amount of the home currency (U.S. dollars in our example) that
is initially invested (Ah).
• The spot rate (S) in dollars when the foreign currency is purchased.
• The interest rate on the foreign deposit (if).
• The forward rate (F) in dollars at which the foreign currency will be
converted back to U.S. dollars.
B - INTEREST RATE PARITY (IRP)
• In equilibrium, the forward rate differs from the spot rate by a
sufficient amount to offset the interest rate differential between two
currencies.
• On the condition of IRP, covered interest arbitrage is no longer
feasible.
• Investors should expect to earn the same rate of return in all
countries after adjusting currency depreciation/appreciation.
𝟏 + 𝒊𝒉
𝒑= −𝟏
𝟏 + 𝒊𝒇
B - INTEREST RATE PARITY (IRP)
Quote
EUR Spot Rate $1.13
EUR one-year $1.12
Forward
Deposit Rate
Interest rate on 6.0%
dollars
Interest rate on 6.5%
euros

Does covered interest arbitrage exists?

2. DERIVATION OF IRP
• To determine forward premium or discount
• To determine the forward rate
Example: Assume that the Mexican peso exhibits a 6-month interest
rate of 6 percent, while the U.S. dollar exhibits a 6-month interest rate
of 5 percent. From a U.S. investor’s perspective, the U.S. dollar is the
home currency. According to IRP, the forward rate premium of the
peso with respect to the U.S. dollar should be?
B - INTEREST RATE PARITY (IRP)
Example: A US investor has $100 and is considering two bonds
of similar risks.
US 1-year bond pays 10% interest rate
Canadian 1-year bond pays 8% interest rate
Spot rate (CAD/USD) = 2
What is the expected 1-year forward rate that the investor
will be indifferent between two bonds?
DERIVATION OF IRP
1. If the forward premium/ discount is equal to the interest rate
differential (on the condition of IRP), CIA will not be possible.
2. Home interest rate is higher than foreign interest rate: forward rate
should exhibit the forward premium
3. Home interest rate is less than foreign interest rate: forward rate
should exhibit the forward discount
SIMPLIFIED EQUATION OF IRP
The relationship between the forward premium (or discount) and
the interest rate differential according to IRP is simplified in an
approximated form as follows:
P: forward premium or discount
𝑭−𝑺 F: forward rate in dollars
𝒑= ≅ 𝒊h − 𝒊f
𝑺 S: spot rate in dollars
ih: home interest rate
if: foreign interest rate
3. GRAPHIC ANALYSIS OF IRP

The location of the points provides an indication of whether CIA is

worthwhile.
TEST FOR EXISTENCE OF IRP
• To test whether IRP exists, collect actual interest rate differentials
(assets of similar risk and maturity) and forward premiums/discounts
for various currencies, and plot them on a graph
• IRP holds when covered interest arbitrage is not possible or
worthwhile.
• IRP holds, investors can not use covered interest arbitrage to earn
higher return than those achieved in their home country.
4. CONSIDERATIONS OF IRP
• Transaction costs: The actual point reflecting the interest rate
differential and forward rate premium must be farther from the IRP
line to make covered interest arbitrage worthwhile.
• Political risk: A crisis in the foreign country could cause its
government to restrict any exchange of the local currency for other
currencies.
• Differential tax laws: Covered interest arbitrage might not be
feasible when considering after-tax returns
GRAPHIC ANALYSIS OF IRP
Transaction costs
SUMMARY
• Locational arbitrage may occur if foreign exchange quotations
differ among banks. The act of locational arbitrage should force
the foreign exchange quotations of banks to become realigned,
and locational arbitrage will no longer be possible.
• Triangular arbitrage is related to cross exchange rates. A cross
exchange rate between two currencies is deter- mined by the
values of these two currencies with respect to a third currency.
SUMMARY
• Covered interest arbitrage is based on the relationship between the forward rate
premium and the interest rate differential. The size of the premium or discount
exhibited by the forward rate of a currency should be about the same as the
differential between the interest rates of the two countries of concern. In general
terms, the forward rate of the foreign currency will contain a discount (premium)
if its interest rate is higher (lower) than the U.S. interest rate.
• If the forward premium deviates substantially from the interest rate differential,
covered interest arbitrage is possible. In this type of arbitrage, a foreign short
term investment in a foreign currency is covered by a forward sale of that foreign
currency in the future. In this manner, the investor is not exposed to fluctuation in
the foreign currency’s value.
SUMMARY
• Interest rate parity (IRP) is a theory that states that the size of the
forward premium (or discount) should be equal to the interest rate
differential between the two countries of concern. When IRP exists,
covered interest arbitrage is not feasible because any interest rate
advantage in the foreign country will be offset by the discount on the
forward rate. Thus, the act of covered interest arbitrage would
generate a return that is no higher than what would be generated by a
domestic investment.