Interest rate parity L8

Question 1

Types of Arbitrage

Answer 1

• Locational arbitrage
• Triangular arbitrage
• Covered interest arbitrage

Question 2

Locational arbitrage

Answer 2

• Capitalising on discrepancies in prices across different locations by buying the currency where it is cheap and immediately selling where it is priced higher
• drives prices to realign in the locations

Question 3

Covered interest arbitrage

Answer 3

• capitalising on the interest rate differential between two countries while covering your exchange rate risk with a forward contract

Question 4

interest rate parity (IRP)

Answer 4

In equilibrium, the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies

Question 5

Covered Interest Parity

Answer 5

• a no-arbitrage relationship between spot/forward exchange rates and nominal interest rates associated with two currencies

Question 6

Uncovered interest rate parity

Answer 6

• the difference in interest rates between two countries will equal the relative change in the exchange rate over the same period

Question 7

Triangular arbitrage

Answer 7

• keeps cross-rates in line with exchange rates
• when one trades three different currencies to make a profit, arising from inconsistent cross-rates