Chapter 7 (Final Exam) Flashcards
What is arbitrage?
the process of capitalizing on price discrepancies to make a risk-free profit.
What are the three forms of international arbitrage?
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
What is locational arbitrage?
Buying a currency where it’s cheap and selling it where it’s more expensive.
Result: It causes exchange rates in different locations to realign.
What is triangular arbitrage?
Currency transactions in the spot market to profit from differences in cross exchange rates.
Consideration: Bid/ask spreads can reduce profits.
What is covered interest arbitrage?
Earning profit from interest rate differences between two countries while hedging (eliminating) exchange rate risk using forward contracts.
Result: Forward rates adjust to maintain equilibrium.
Realignment in arbitrage
Locational arbitrage aligns exchange rates across banks.
Triangular arbitrage ensures cross exchange rates are correct.
Covered interest arbitrage adjusts forward rates to eliminate profit opportunities.
Interest Rate Parity (IRP)
The forward rate adjusts from the spot rate to account for the difference in interest rates between two currencies.
Why is IRP important?
If IRP holds, covered interest arbitrage is not feasible because any advantage in foreign interest rates is offset by the forward rate discount or premium.
Note:
If forward premium is equal to interest rate differential, then covered interest arbitrage will not be feasible
What affects the variation in forward premiums?
Interest rate differentials, inflation, and changes in spot rates over time.
What factors affect arbitrage?
Transaction Costs: Can reduce or eliminate arbitrage profits.
Political Risks: May restrict currency exchanges.
Tax Laws: Affect returns on investments.
What is the importance of arbitrage?
-Keeps foreign exchange markets orderly by reducing discrepancies.
-Helps avoid excessive transaction costs.
