Interest Arbitrage Flashcards
Arbitrage
Capitalising on a discrepancy in quoted prices to make a risk less profit
3 types of arbitrage
Locational arbitrage
Triangular arbitrage
Covered interest arbitrage
Locational arbitrage
When a bank’s buying price (bid price) is higher than anothers selling price (ask price) for the same currency
(Overpay so other benefits)
Triangular arbitrage
When a cross exchange rate quote differs from the rate calculated from spot rate quotes.
Beal Bank:
Bid price of NZD: £0.020
Ask price of NZD: £0.022
Yardley Bank:
Bid price of NZD: £0.018
Ask price of NZD: £0.019
Is locational arbitrage possible? How much profit if given £1M?
Yes - bid price of one bank (Beal) > ask price of other (Yardley)
£1M / 0.019 to convert into NZD.
Then sell at 0.020
-£1M to get profit
Interest arbitrage
Transfer of short term liquid funds abroad to earn a higher rate of return
(Can be covered or uncovered)
(Like hot money)
Uncovered interest arbitrage vs covered
Uncovered has foreign exchange risk - currency could depreciate during investment period
Covered - spot purchase of foreign currency + sale of the forward of foreign coherency to offset (remove FE risk)
Carry trade
Borrowing low-yielding currencies and lending in high yielding currency’s
Comparing arbitrage strategies
Locational: capitalizes on discrepancies in exchange rates ACROSS LOCATIONS e.g just across banks
Triangular: capitalizes on discrepancies in cross-exchange rates.
Covered: capitalizes on discrepancies interest between the forward rate and the arbitrage interest rate differential.
Discrepancies
Trigger arbitrage, eliminating discrepancy, making FEM more orderly.
(Since they have been taken advantage of, market corrects itself)
Forward rate can differ from the spot rate by an amount that sufficiently offsets the interest rate differential between countries.
What is this known as?
Following this, what is no longer feasible?
IRP
Covered interest arbitrage (buy spot sell forward to remove FER) is not possible anymore.
IRP
A currency is worth what it can earn.
(Interest differential = difference between forward and spot rates of their respective currencies)
What is the return of a currency formula in IRP
The interest rate on that currency + expected rate of appreciation over a given period
When does IRP prevail
IRP prevails when return (interest rate of currency+expected appreciation) on 2 currencies are equal.
Example to show IRP.
Consider 2 methods investor can use to convert pounds into dollars.
A - invest pounds at the risk-free rate. Then convert into dollard at the maturity. (Just like previous maths examples)
B - invest dollars in US market instead. When no arbitrage opportunities exist, returns from both options equal (IRP holds)
What if IRP is violated
An arbitrage opportunity exists (since returns are not equal)
Example of IRP violated:
If forward rates same as spot rate, but interest rates different (interest differential is different from difference in forward and spot rates of respective currencies), investors would…
An arbitrage opportunity exists as returns aren’t equal.
They would borrow in the currency with the lower rate, then convert at spot rates, enter forward to convert cash plus expected interest at the same rate, invest money in the higher rate, then convert back (and repay for original borrowing)
Derivation of IRP & Forward premium
Forward premium formula (2 formulas)
Forward rate formula (hint, uses forward premium)
Forward premium (p)
1+home interest
/
1+foreign interest
-1
Or short form if interest differential is small:
Home Interest - foreign interest
Forward rate (F)
F = S (1+p)
S is spot exchange rate
Interpretation of IRP
It does not mean that both local and foreign investors will earn the same returns.
It JUST means investors cannot use CIA technique to achieve higher returns.
Does IRP hold in real life (yes and no)
Yes in general (forward rate and spot rate differ by amount that offset interest rate differential, making CIA not possible since returns equal)
Some deviations but often not significant enough to make CIA worthwhile (not much profit to be made)
What makes CIA unworthwhile in reality (3)
Transaction costs (reduce arbitrage profits)
Political risk
Tax law
Carry trades -
- When will we sell/buy forward (pg 30)
Carry trade - borrowing low rate, lend/invest in high!
(Hope the low rate doesn’t appreciate)
Recall forward formula S (iH - iF)
Sell forward if forward rate > expected spot rate
Buy forward if forward rate < expected spot rate
If arbitrage is actually possible though, how long does the arbitrage opportunity tend to exist?
Short term, as discrepancies get corrected and IRP restored.
Borrowing in the low yield will increase interest rate, and lending in high yield will lower the interest rate, so it balances where there is no more interest differential to profit from.
If foreign exchange markets are efficient… (2)
Prices reflect all possible info
Forward rates accurately predict future spot rates
Eurocurrency
Eurodollar
Euro sterling
Eurodeposit
Eurocurrency - Commercial bank holds foreign deposits
Eurodollar - A deposit in US dollars in a British bank
Eurosterling - pound deposit in French bank
Eurodeposit - euro deposited in Swiss bank
Reasons for offshore deposits (3)
Interest rates abroad often higher on short term deposits
International corporations convenience - hold abroad in currency they need for payments.
Overcome domestic credit restrictions by borrowing in the Eurocurrency market.
Eurobonds and Euronotes
Long term debt securities sold outside borrowers country to raise capital in a foreign currency to which the bonds are sold
Euronotes - medium term financial instruments to borrow funds in a foreign currency to which notes are sold
Is exchange rate risk relevant
1st argument against:
Purchase power parity argument 1 point and Eval)
Exchange rate movements will be matched by price movements.
Eval: PPP does not necessarily hold. (Next lec- only for long term, individual traded goods etc)
Is exchange rate risk relevant -
2nd argument: Investor hedge argument (2)
Investors make approximate estimates of effect of exchanges rate changes on share value.
MNC shareholders can hedge against such exchange rate fluctuations on their own
Is exchange rate risk relevant -
3rd argument against: currency diversification argument (1 pro and Eval)
An MNC that is diversified across different countries it should not be offset exchange rate risk
Eval: naive, few are well diversified
Is exchange rate risk relevant -
4th stakeholder diversification argument
It is easier for shareholders to diversify than MNCs
Is exchange rate risk relevant - response from MNCs
They believe exchange risk is relevant - so MNCs try hedging strategies
Types of exposure
Transaction
Economic
Translation
Transaction exposure
Degree to which future transactions can be affected by exchange rate fluctuations
How can we measure transaction exposure
Estimate net cash inflows or outflows in each currency, then measure potential impact of the exposure.
So how do we estimate net currency flows
MNCs anticipate it, then make a point estimate (or range)
Measuring exposure - what 2 components are needed
Measuring variability and correlation among movements of currencies (to see how they move in relation to each other)
Formula involves standard deviation (for currency variability) and correlation coefficients
What else can be used to measure transaction exposure
Value at risk
PG 49
Economic exposure
Degree to which a firms present value of future cash flows can be influenced by exchange rate fluctuations
How could a purely domestic firm still have economic exposure
If it faces foreign competition in its local markets
How is economic exposure measured
Assess sensitivity of earnings to exchange rates
If a currency depreciates revenues improve (WPIDEC) but costs can increase.
What factors determines earnings/ profits? (3)
Size of sales and costs
Elasticity of demand (elastic - a lot more people will buy increasing revenue)
Elasticity of supply (elastic - easy to switch imported costs?)
Economic exposure expression (assume we are assessing exposure to only one other foreign currency)
So we are looking at earnings upon exchange rate of one other currency
PCFt = a₀ + a₁et + μt
PCFt Present Cash Flows = % change in inflation adjusted cashflows over t
et = % change in exchnage rate over t
μt = error
α₀ = constant
Translation exposure
Exposure of an MNC’s consolidated financial statments to exchange rate fluctuations
(I.e when converting earnings earnt from abroad subsidiaries onto the income statement, thus subject to exchange rates
E.g a weakness of euro caused US MNCs reporting lower earnings than expected. Since when translating euros back to dollars, now get less dollars
What does a degree of translation exposure depend on? (3)
Proportion of business conducted in foreign subsidiaries (if more, convert back more, so more risk)
Locations of the foreign subsdiaries
Accounting methods
Does translation exposure matter
1st argument against: cash flow perspective
translation of financial statements does not affect MNC’s cash flows, so many firms do not hedge against translation exposure
(So hedge against exchange rate risk, but not translation exposure!)
Does translation exposure matter
2nd argument for yes: stock price perspective (and eval)
MNC’s translation exposure affects consolidated earnings, which investors refer to when assessing, so valuation may be affected
Eval: efficient market should be able to separate out the translation effect and make investors understand it does not affect their wealth.
