Chapter 7- International Arbitrage And Interest Rate Parity Flashcards
International Arbitrage
- If discrepancies happen in the foreign exchange market, with quoted prices of currencies varying from what their market prices should be, then certain market forces will realign the rates. This realignment occurs as a result of arbitrage
–> Arbitrage is loosely defined as capitalizing on a discrepancy in quoted prices by making a riskless profit.
–> In many cases, such a strategy involves no risk and does not require that the investor’s funds be tied up.
Arbitrage will cause prices to realign
Three forms of arbitrage:
- Locational arbitrage
- Triangular arbitrage
- Covered interest arbitrage
Locational Arbitrage
When quoted exchange rates vary among locations, participants in the foreign exchange market can capitalize on the discrepancy.
Locational arbitrage is defined as the process of buying a currency at the location where it is priced lower and immediately selling it at another location where it is priced higher. (See Exhibit 7.1)
Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy. (See Exhibit 7.2)
Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies.
Locational Arbitrage - Example
-This is considered to be one round-trip transaction in locational arbitrage.
-If you start with $10,000 and conduct one round-trip transaction, how many U.S. dollars will you end up with?
The $10,000 is initially exchanged for NZ$15,625 ($10,000/$0.640 per New Zealand dollar) at North Bank. Then the NZ$15,625 are sold for $0.645 each to yield a total of $10,078 (NZ$15,625*$0.645 per NZD). Thus, your gain from locational arbitrage is $78 ($10,078-$10,000).
-Your gain may appear to be small relative to your investment. However, consider that you
*did not have to tie up any of your funds
*round-trip transaction could take place over a telecommunications network within a matter of seconds
*if you could use a larger sum of money for the transaction, then your gains would be larger.
*finally, you could continue to repeat this round-trip transaction until North Bank’s ask price is no longer less than South Bank’s bid price.
-Quoted prices will react to the locational arbitrage strategy used by you and other foreign exchange market participants.
-The high demand for New Zealand dollars at North Bank (resulting from arbitrage activity) will cause a shortage of New Zealand dollars there. As a result of this shortage, North Bank will raise its ask price for New Zealand dollars.
-In turn, the excess supply of New Zealand dollars at South Bank (resulting from sales of New Zealand dollars to South Bank in exchange for U.S. dollars) will force South Bank to lower its bid price. -As the currency prices are adjusted, the gains from locational arbitrage will be reduced. Once the ask price of North Bank equals the bid price of South Bank, locational arbitrage will no longer occur. Prices may adjust in a matter of seconds or minutes from the time when locational arbitrage occurs.
Triangular Arbitrage
Defined as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies. (See Exhibits 7.3, 7.4, & 7.5)
Gains from triangular arbitrage: Currency transactions are conducted in the spot market to capitalize on the discrepancy in the cross exchange rate between two countries.
Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage.
Realignment due to triangular arbitrage forces exchange rates back into equilibrium. (See Exhibit 7.6)
Arbitrage Example with Transaction Costs
The previous example is simplified in that it does not account for transaction costs (bid ask spread). In reality, there is a bid quote and an ask quote for each currency, which means that the arbitrageur incurs transaction costs that can reduce or even eliminate the gains from triangular arbitrage. The following example illustrates how bid and ask prices can affect arbitrage profits.
The cross rate (ask) that British pound in MYR should be is $1.61/GBP / $0.201/MYR=MYR8.00995/GBP
This calculated cross rate is greater than the quoted cross rate MYR8.20/GBP there is a triangular arbitrage opportunity
Step 1: use USD to buy GBP at the ask price $1.61 (i.e. the price the bank will sell GBP to you)
Step 2: exchange GBP for MYR at MYR8.1 per GBP
Step 3: exchange MYR for USD at $0.2 per MYR
Impact of Triangular Arbitrage
-The realignment that results from triangular arbitrage activity is summarized in the second column of Exhibit 7.6.
-This realignment will probably occur quickly, thereby preventing continued benefits from triangular arbitrage.
-The discrepancies assumed here would seldom occur at a single bank; it is much more likely that triangular arbitrage would require three transactions at three separate banks.
Activity 1: Participants use dollars to purchase pounds.
Impact: Bank increases its ask price of pounds with respect to the dollar.
Activity 2: Participants use pounds to purchase Malaysian ringgit.
Impact: Bank reduces its bid price of the British pound with respect to the ringgit; that is, it reduces the number of ringgit to be exchanged per pound received.
Activity 3: Participants use Malaysian ringgit to purchase U.S. dollars.
Impact: Bank reduces its bid price of ringgit with respect to the dollar.
Covered Interest Arbitrage Process:
Steps involved in covered interest arbitrage
–> Defined as the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract.
–> Consists of two parts: (Exhibit 7.7)
- Interest arbitrage: the process of capitalizing on the difference between interest rates between two countries.
- Covered: hedging the position against exchange rate risk.
Realignment due to covered interest arbitrage causes market realignment (i.e. when forward rate displays a discount that equals the interest rate differential).
Timing of realignment may require several transactions before realignment is completed.
International Arbitrage continued:
Recall that locational and triangular arbitrage do not tie up funds; thus, any profits are achieved instantaneously. In the case of covered interest arbitrage, however, the funds are tied up for some period of time (90 days in our example).
This strategy would not be advantageous if it earned2%or less, because you could earn2%on a domestic deposit. The termarbitragehere suggests that you can guarantee a return on your funds that exceeds the returns you could achieve domestically.
Covered interest arbitrage is sometimes interpreted to mean that the funds to be invested are borrowed locally; that is, it is assumed that investors do not use their own funds.
Covered Interest Arbitrage (continued)
Realignment is focused on the forward rate
–> the forward rate is likely to experience most if not all of the adjustment needed to achieve realignment since forward rate is less liquid and more sensitive to shift in demand or supply caused by covered interest arbitrage than spot rate.
Arbitrage Example When Accounting for Spreads
–> Investor must account for the effects of the spread between the bid and ask quotes and of the spread between deposit and loan rates.
Covered interest arbitrage by Non-U.S. investors
–> The concept of covered interest arbitrage applies to any two countries for which there is a spot rate and a forward rate between their currencies as well as risk-free interest rates quoted for both currencies.
Comparison of Arbitrage Effects
The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in different locations.
The threat of triangular arbitrage ensures that cross exchange rates are properly set.
The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy.
Thus, arbitrage tends to allow for a more orderly foreign exchange market.
How arbitrage reduces transaction costs:
Locational arbitrage limits the differences in a spot exchange rate quotation across locations, while covered interest arbitrage ensures that the forward rate is properly priced. Thus, an M N C’s managers should be able to avoid excessive transaction costs.
Interest Rate Parity
-When market forces cause interest rates and exchange rates to adjust such that covered interest arbitrage is no longer feasible, the result is an equilibrium state known as 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.
what the forward premium of the foreign currency should be under IRP:
p = ((1 + ih) / (1+if)) - 1
where
p= forward premium
ih = home interest rate
if = foreign interest rate
Determining the Forward Premium
Effect of the interest rate differential: The relationship between the forward premium (or discount) and the interest rate differential according to I R P is simplified in an approximated form:
p = (F-S)/S =/ (approx) ih- if
where
p = forward premium (or discount)
F = forward rate in dollars
S = spot rate in dollars
ih = home interest rate
if = foreign interest rate
Implications: If the forward premium is equal to the interest rate differential as just described, then covered interest arbitrage will not be feasible.
Graphic Analysis of Interest Rate Parity
For all situations in which the foreign interest rate ishigherthan the home interest rate, the forward rate should exhibit a discount approximately equal to that difference.
Points representing a discount: points A and B When the foreign interest rateexceeds the home interest rateby1percent, the forward rate should exhibit a discount of1percent. This is represented by point A on the graph.
Points representing a premium: points C and D
Points representing I R P: points A, B, C, D
Points below the I R P line: points X and Y
–> U.S. investors can engage in covered interest arbitrage and earn a higher return by investing in foreign currency after considering foreign interest rate and forward premium or discount. Since point X is not on the IRP line, we should expect that covered interest arbitrage will be beneficial for investors in the home country. They earn an additional3percentage points on the foreign deposit, and this advantage is only partially offset by the1percentforward discount on the forward sale of the foreign currency at the time when the deposits mature.
Points above the I R P line: point Z
–> U.S. investors would achieve a lower return on a foreign investment than on a domestic one.
