L8

Question 1

Arbitrage:

Answer 1

Taking advantage of a discrepancy in quoted prices by making a riskless profit
* will cause the market to realign

Question 2

3 forms of Arbitrage

Answer 2

1. Location
2. Triangular
3. Covered Interest

Question 3

Location Arbitrage

Answer 3

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

Question 4

Why might there be misalignments (Locational Arbitrage)

Answer 4

• price not accurate
• regulations and restrictions concerning buying and selling currency
• Diff doesn’t include tx cost and commission
• Element of risk not identified

Question 5

Triangular Arbitrage (TA)

Answer 5

cur trans in spot market to capitalize on diff in cross exch between 2 curr
*Realignment due to triangular forces exch back into equilibrium

Question 6

Impact of TA

Answer 6

1. Participants use Cur2/Cur1 to sell home and buy foreign- Banks Reduce its bid price of Cur1 with Cur2
2. People use Cur2 to buy Cur”b”- bank reduces its bid price of Cur2 with Cur”b”
3. People use Cur”b” to buy Cur1- bank reduces its bid price of Cur”b” with Cur1

Question 7

CIP- Covered Interest parity

Answer 7

no abrit between spot + FWD exch and nominal interest rates with 2 cur

Question 8

CIA- Covered Interest Arbitrage

Answer 8

Process of Capitalizing on interest rate diff between 2 diff country while covering your exch risk with a FWD

Question 9

CIA 2 parts

Answer 9

1. Interest arbit- diff between interest rates between 2 countries
2. covered- hedging position against exch risk

Question 10

CIA- Realignment

Answer 10

CIA causes market realignment as FWD likely to experi most of adjustment needed to achieve
*timing- may take several trans before realignment

Question 11

Theory of CIA

Answer 11

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

Question 12

Market Adjustment to restore IRP- Eliminate Arbit

Answer 12

increase Borrowing, Interest dom ^
Investing in foreign, Interest Foreign= down

Question 13

UIP- Uncovered Interest Parity

Answer 13

Relationship- change in expected and interest rate
Arbit= expected returns

Question 14

Currency Carry trade occurrence

Answer 14

UN interest arbitrage opportunity when UIP doesn’t hold

Question 15

Carry trade involvements

Answer 15

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

Question 16

Carry trade Example-
Iu.s.a. = 5%, Iuk= 8%

Answer 16

e= Id- If
5-8= -3%
under UIP £ is expected to depreicate by 3% or there would be an arbtri opp

Question 17

If UIP and CIP hold

Answer 17

Unbiased= Fo=E(s1)
Fwd exch= expected value of future spot exch

Question 18

If it UIP and CIP dont hold

Answer 18

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

Question 19

Diff of arbi effects

Answer 19

1. locational- threat makes sures that quoted exch rates are similar across banks
2. TA- Threat makes sures that cross exch are properly set
3. CIA- Threat ensures that fwd exch are properly set

Arbi- tends to allow for more orderly FX market

Question 20

IRP (Interest Rate Parity)

Answer 20

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

Question 21

FWD Prem/ Disc

Answer 21

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

Question 22

IRP doesnt imply

Answer 22

that investors from diff countries will earn same reutrn

Question 23

Does IRP hold

Answer 23

Compare FWD rate with I quotes occurring at the same time
Hard to do as info is limited

Question 24

Assessing IRP

Answer 24

1. Default Risk
2. Transaction cost
3. Political risk
4. Diff tax laws

Question 25

Variations in FWD

Answer 25

• FWD prem across maturities
• changes in fwd prem overtime

Question 26

Why FWD changes

Answer 26

Interest diff
Inflation diff
change due to change in prem