L8 Flashcards
Arbitrage:
Taking advantage of a discrepancy in quoted prices by making a riskless profit
* will cause the market to realign
3 forms of Arbitrage
- Location
- Triangular
- Covered Interest
Location Arbitrage
process of buying a currency at a location where its priced cheaply and selling it at another location where price is higher
* Bid Price of 1 bank is lower than the other Ask Price
Why might there be misalignments (Locational Arbitrage)
- price not accurate
- regulations and restrictions concerning buying and selling currency
- Diff doesn’t include tx cost and commission
- Element of risk not identified
Triangular Arbitrage (TA)
cur trans in spot market to capitalize on diff in cross exch between 2 curr
*Realignment due to triangular forces exch back into equilibrium
Impact of TA
- Participants use Cur2/Cur1 to sell home and buy foreign- Banks Reduce its bid price of Cur1 with Cur2
- People use Cur2 to buy Cur”b”- bank reduces its bid price of Cur2 with Cur”b”
- People use Cur”b” to buy Cur1- bank reduces its bid price of Cur”b” with Cur1
CIP- Covered Interest parity
no abrit between spot + FWD exch and nominal interest rates with 2 cur
CIA- Covered Interest Arbitrage
Process of Capitalizing on interest rate diff between 2 diff country while covering your exch risk with a FWD
CIA 2 parts
- Interest arbit- diff between interest rates between 2 countries
- covered- hedging position against exch risk
CIA- Realignment
CIA causes market realignment as FWD likely to experi most of adjustment needed to achieve
*timing- may take several trans before realignment
Theory of CIA
The diff between the dom interest and foreign interest rate is equal to the current FWD rate over the current spot rate
(1+Id)/(1+If)= Fo/So
Market Adjustment to restore IRP- Eliminate Arbit
increase Borrowing, Interest dom ^
Investing in foreign, Interest Foreign= down
UIP- Uncovered Interest Parity
Relationship- change in expected and interest rate
Arbit= expected returns
Currency Carry trade occurrence
UN interest arbitrage opportunity when UIP doesn’t hold
Carry trade involvements
borrowing in Cur with low I and investing in Cur with high I without hedging
profits= diff between I and the rate of appreciate (deprec) of the low (high) I cur
Carry trade Example-
Iu.s.a. = 5%, Iuk= 8%
e= Id- If
5-8= -3%
under UIP £ is expected to depreicate by 3% or there would be an arbtri opp
If UIP and CIP hold
Unbiased= Fo=E(s1)
Fwd exch= expected value of future spot exch
If it UIP and CIP dont hold
Fo= Fwd is a biased predictor of the future spot rate
* one side wins other loss- if loss expected no investor will take it up
Diff of arbi effects
- locational- threat makes sures that quoted exch rates are similar across banks
- TA- Threat makes sures that cross exch are properly set
- CIA- Threat ensures that fwd exch are properly set
Arbi- tends to allow for more orderly FX market
IRP (Interest Rate Parity)
In equilibrium the fwd difss from the spot by a sufficient amount to offset the interest rates between 2 countries
P= [(1+Id)/(1+If)] - 1
FWD Prem/ Disc
effect of the I diff: relationship between the Fwd prem or disc and the I diff is:
P= (F-S/S) Roughly equals Id-If
If F larger than S= prem
cur must deprec in fwd or their would be an arbti
IRP doesnt imply
that investors from diff countries will earn same reutrn
Does IRP hold
Compare FWD rate with I quotes occurring at the same time
Hard to do as info is limited
Assessing IRP
- Default Risk
- Transaction cost
- Political risk
- Diff tax laws
Variations in FWD
- FWD prem across maturities
- changes in fwd prem overtime
Why FWD changes
Interest diff
Inflation diff
change due to change in prem
