International arbitrage & Interest Rate Parity

Question 1

Name three forms of arbitrage

Answer 1

Locational arbitrage
Triangular arbitrage
Covered interest arbitrage

Question 2

Explain arbitrage

Answer 2

Defined as capitalizing on a discrepancy in quoted prices by making a riskless profit.
Arbitrage will cause prices to realign.

Question 3

Explain locational arbitrage

Answer 3

Process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy.

Question 4

How does realignment due to locational arbitrage work?

Answer 4

Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies.

Question 5

Define triangular arbitrage

Answer 5

Defined as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies.
Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage.

Question 6

How does realignment work in case of triangular arbitrage?

Answer 6

Realignment due to triangular arbitrage forces exchange rates back into equilibrium.

Question 7

What is the impact on ask price in the bank of a participant using dollar to purchase pounds

Answer 7

Banks increases its ask price of pounds with respect to dollar.

Question 8

What is the impact on ask price in the bank of a participant using Ringgit to purchase Dollar

Answer 8

Bank reduces its bid price of ringgit with respect to dollar.

Question 9

Explain covered interest arbitrage

Answer 9

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:
Interest arbitrage: the process of capitalising on the difference between interest rates between two countries.
Covered: hedging the position against interest rate risk.

Question 10

Explain how realignment works in case of covered interest arbitrage

Answer 10

Realignment due to covered interest arbitrage causes market realignment.
Timing of realignment may require several transactions before realignment is completed.
Realignment is focused on the forward rate: it experiences most if not all of the adjustment needed to achieve realignment.

Question 11

Where does covered interest arbitrage existing for non US investors

Answer 11

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.

Question 12

Why is accounting for spreads important - covered interest

Answer 12

Investor must account for the effects of the spread
between the bid and ask quotes and of the spread between deposit and loan rates.
May cause the yield to be less than if you and just invested the funds domestically making arbitrage not feasible.

Question 13

What is the effect of the 3 types of arbitrage

Answer 13

Locational arbitrage ensures that quoted exchange rates are similar across banks in different locations.
Triangular arbitrage ensures that cross exchange rates are properly set.
Covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate the discrepancy.

Question 14

In equilibrium are forward rate and spot rate equal?

Answer 14

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

Question 15

Explain interest rate parity

Answer 15

Interest rate parity (IRP) is the fundamental equation that governs the relationship between interest rates and currency exchange rates.
Interpretation: Interest rate parity does not imply that investors from different countries will earn the same returns.

Question 16

What is the formula for interest rate parity

Answer 16

p=((1+ih)/(1=if))-1
p = forward premium
ih = home interest rate
if = foreign interest rate

Question 17

How can the relationship between the forward premium/discount and interest rate differential be approximated by IRP

Answer 17

P=(F-S)/S = ih-if
approx
F=Forward rate in dollars
S= spot rate in dollars

Question 18

When is covered interest arbitrage not feasible according to IRP

Answer 18

If the forward premium is equal to the interest rate differential P=(F-S)/S = ih-if, then covered interest arbitrage will not be feasible.

Question 19

How do we graph the IRP line?

Answer 19

X axis : Forward premium (+) or discount(-)
Y axis: ih-if (%)

Question 20

How do we interpret graph of the IRP line?

Answer 20

Points representing IRP are on the line
Points below the IRP line: points X and Y means domestic 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.
Points above the IRP line: point Z means U.S. investors would achieve a lower return on a foreign investment than on a domestic one. Hence there is potential covered interest arbitrage for foreign investors

Question 21

How does the IRP line graph change as people take advantage of covered interest arbitrage

Answer 21

For points to the right of the IRP line, investors in the home country should consider using covered interest arbitrage, since a return higher than the home interest rate (ih) is achievable.
As investors and firms take advantage of such opportunities, the point will tend to move toward the IRP line.
Covered interest arbitrage should continue until the interest rate parity relationship holds.

Question 22

Name some considerations when assessing interest rate parity

Answer 22

Transaction costs - make covered interest arbitrage not worthwhile.
Political risk - may be restrictions on exchanging currency
Differential tax laws - covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns.