Chapter 7: International Arbitrage and Interest Rate Parity

Question 1

What is Locational Arbitrage?

Answer 1

the process of buying a currency at a location where it is priced cheap and then immediately selling it at some other location where it is priced higher.

Question 2

How to gain on locational arbitrage

Answer 2

1. Amount of money that you use to capitalize on the exchange rate discrepancy

2.the size of that discrepancy.

Question 3

Example: Locational Arbitrage

Bank 1:
Bid = 0.635
Ask = 0.640

Bank 2:
Bid = 0.645
Ask = 0.650

10,000 start

Answer 3

1. 10,000 / .640 = 15,625 foreign
2. 15625 * .645 = 10,078 USD (78 profit)

Question 4

Suppose that Sailbridge Bank and Signbit Bank both act as financial intermediaries in the foreign exchange market. The quotations for the British pound at the two banks are shown in the following table:

Sailbridge (British pound)
Bid $1.22
Ask $1.27

Signbit (British pound)
Bid $1.30
Ask $1.35

Suppose that you have $12,000 to use to engage in locational arbitrage. What is profit/loss?

Answer 4

a. 12,000 / 1.27 = 9,448.82 pounds

b. 9,448.82 * 1.30 = 12,283.47

283.47 profit

Question 5

Realignment due to locational arbitrage

Answer 5

Shortage of foreign at North Bank , Excess supply at South Bank

South bank lower bid, North bank raise ask price, Prices change until =

Question 6

What is triangular arbitrage?

Answer 6

action to capitalize on a discrepancy where the quoted cross exchange rate is not equal to the rate that should exist at equilibrium.

Question 7

Example: Simple triangular aribtrage

Suppose that Cloudastries Bank is a U.S.-based financial intermediary that serves the foreign exchange market. Assume that this bank is willing to both purchase and sell currency for the same rate. In other words, assume there is no bid/ask spread.

Suppose Cloudastries has made the following direct quotations:
Currency / Dollar Spot Rate
Mexican Peso $0.40
Euro $1.60

Additionally, Cloudastries has quoted a cross exchange rate of 1 euro=4.03 pesos

a. What is the cross exchange rate of euro?
b. Suppose that you have $20,000 with which to try to capitalize on triangular arbitrage. What is profit/loss?

Answer 7

a. 1.60 / 0.40 = 4 pesos

b. 20,000 USD / 1.60 us per euro = 12,500 euros
12,500 euros * 4.03 pesos per euro = 50,375 pesos
50,375 * 0.40 per peso = 20,150 USD

150 profit

Question 8

Realignment due to triangular aribtrage

Answer 8

Basically market forces push back to

Question 9

What is covered interest arbitrage?

Answer 9

Capitalize on int. rate differential between two countries while also covering exchange rate risk w/ a forward contract

investment in a foreign money market security with a simultaneous forward sale of the currency denominating that security.

Question 10

Basic example: covererd interest arbitrage

800,000 to invest
current spot rate of pound 1.60
90 day foward rate of pound 1.60
90 day interest rate in US 2%
90 day interest rate in UK 4%

Answer 10

1. Day 1: Convert 800,000 US to UK (800,000/1.60) = 500,000 pounds, deposit in UK
2. Day 1: sell 520,000 pound 90 day foward contract (500,000 + 4% interest)
3. Convert 520,000 pounds to 832,000 USD (520,000* 1.60 (contract rate))

Question 11

What is arbitrage?

Answer 11

Arbitrage: suggests you can get return on funds that exceed what you can achieve domestically

Question 12

Realignment due to covered interest arbitrage

Answer 12

Sell pounds -> downward pressure on the forward rate (if forward < spot then cant arbitrage)
Could also result in upward pressure in spot rate

Question 13

Comparing/Summary of Arbitrage Types

Answer 13

Locational: capitalize on discrepencies in exchange rates across location
* realign focus on Bid/ask

Triangular: capitalize of discrepencies in cross exchange rates
* realign focus on exchange rates

Covered interest: capitalize on discrepencies between the foward and interest rate differential
* realign focus on forward rates

Question 14

What is Interest Rate Parity (IRP)?

Answer 14

equilibrium condition in which the forward rate premium is equal to the interest rate differential between currencies.
* Market forces change interest + exchange so that covered interest is no longer feasible

Question 15

Example: IRP

1,000,000 US
Spot Rate 0.10 per peso
Interest rate 0.06
Foward rate 0.0990 (to US)

Answer 15

1,000,000/.10 = 10,000,000 MXP
10,000,00 (1 + 0.06) = 10,600,000
10,600,00 * 0.09906 = 1,050,036

Question 16

What is the IRP line

Answer 16

set of points on a graph in which IRP exists, such that the forward rate premium is equal to the interest rate differential between currencies

if IRP holds Covered interest arbitrage not feasible

Question 17

Points below the IRP line

Answer 17

Below/right of the line: Arbitrage feasible for investors in home country (x or y)
* Invest in foreign - upward pressure on spot rate of foreign + downward on forward rate of foreign until reach =

Question 18

Points above the IRP line

Answer 18

Arbitrage feasible for foreign investors (Point Z)
○ Invest in home (us) currency but still earn profit due to discount

• US investors receive less by invest foreign (discount> h-f)

Question 19

Consideration when assessing IRP

Answer 19

Transaction costs
Political risk
Different tax laws

Question 20

Foward premium across maturities

Answer 20

Higher premium more time

Size of premium = size of differences in interest rates??