Interest Arbitrage Flashcards by lew lee

Arbitrage

Capitalising on a discrepancy in quoted prices to make a risk less profit

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3 types of arbitrage

Locational arbitrage
Triangular arbitrage
Covered interest arbitrage

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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)

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Triangular arbitrage

When a cross exchange rate quote differs from the rate calculated from spot rate quotes.

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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

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Interest arbitrage

Transfer of short term liquid funds abroad to earn a higher rate of return

(Can be covered or uncovered)
(Like hot money)

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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)

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Carry trade

Borrowing low-yielding currencies and lending in high yielding currency’s

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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.

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Discrepancies

Trigger arbitrage, eliminating discrepancy, making FEM more orderly.

(Since they have been taken advantage of, market corrects itself)

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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.

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IRP

A currency is worth what it can earn.
(Interest differential = difference between forward and spot rates of their respective currencies)

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What is the return of a currency formula in IRP

The interest rate on that currency + expected rate of appreciation over a given period

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When does IRP prevail

IRP prevails when return (interest rate of currency+expected appreciation) on 2 currencies are equal.

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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)

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What if IRP is violated

An arbitrage opportunity exists (since returns are not equal)

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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)

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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

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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.

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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.