Week 7 Flashcards
What is arbitrage? What is locational arbitrage?
Arbitrage involves making a riskless profit from price differences.
Locational arbitrage occurs when the quoted exchange rates vary among locations (the bid price of one bank being higher than the ASK price of another bank).
The profit will be the amount of money used * the quotation difference.
Arbitrage opportunities will quickly undergo realignment, as the quoted prices will change to reflect the supply and demand.
How do banks try and prevent locational arbitrage?
Technology is used to enable consistent prices, lowering the differences in FOREX quotes in different locations.
What does arbitrage do to supply and demand?
Arbitrage will increase demand at one location (increasing the price) and cause excess supply at the other location (lowering price). This will continue until the ASK rate at one location is equal to the bid rate at the other.
What is triangular arbitrage?
Triangular arbitrage occurs when the market quote of a currency pair is different to the cross rate.
If the cross rate is less than the market rate then we buy the unit currency and convert it to the quoted currency before selling it back for the original currency.
If the cross rate is greater than the market rate then buy the quoted currency and convert it to the unit currency before selling it back to the original currency.
What types of currencies are there in triangular arbitrage?
The home currency, unit currency, and quoted currency.
How is triangular arbitrage eliminated?
it will increase the demand for one currency and decrease the supply of another currency at each step. This will typically lead to the bid price increasing and the ask price decreasing until arbitrage opportunities no longer exist.
What is interest arbitrage? How about covered interest arbitrage?
The process of capitalizing on the difference between interest rates between two countries. Covered interest arbitrage is the same but hedged against exchange risk.
How do we perform covered interest arbitrage?
Convert the lower interest rate currency into the high interest currency. Enter into a forward contract to sell our high interest currency at a point the same as our interest period. When we exercies our contract our profit will be (extra interest * our input money - the loss due to the forward rate). If the forward rate is low enough then this is possible, causing investors to do it. This increases the demand for forward contracts of the high interest currency, hence lowering the forward rate until the arbitrage opportunities disappear.
What does interest rate parity tell us?
The return from home market interest rates should be the same as the return from investing into a foreign market interest rate. This tells us that the forward rate/spot rate = (1+home interest)/(1+foreign interest).
This means the forward premium or discount on a foreign currency equals (the interest home - interest foreign)/(1 + interest foreign). Which we can use to see if there is a covered interest arbitrage opportuenity by comparing the calculated forward rate to the actual rate.
What should we do to profit from interest arbitrage?
If the actual forward contract trades for less than the interest rate parity would suggest then buy the foreign currency, if the actual forward contract is trading higher than interest rate parity would suggest then investors should hold the some currency (foreign investors can use covered interest arbitrage).
What does uncovered interest arbitrage involve?
Borrowing currencies with low interest rates and converting them into currencies with higher interest rates. In this case the investor accepts currency risk, waiting to exchange the higher yielding currency and lower currency later. This can lead to large losses if the high interest currency depreciates alot.
What is the difference between the interest rate parity and International fischer effect?
The interest rate parity applies the interest rate to forward rates, the international Fischer effect applies the interest rate to spot rates.
