Wk7 Flashcards
What is international arbitrage
-Making a riskless profit off of discrepancies in quoted price
- doesn’t require funds to be tied up for a long period of time
- causes price to realign so that there is no futher risk free profit can be made - mechanism
What are the different types of international arbitrage (3)
- locational
- triangular
- covered interest arbitrage
What is locational arbitrage
- When a banks buying price (bid price ) is higher than another banks selling price (ask price) for the same currency
- buying a currency where it’s cheaper and then immédiatetés sell where the price is higher
What is triangular arbitrage
- when you exploit discrepancies in the quoted exchange rate between three diffrent currencies to make a profit - buy low sell high
What interest arbitrage
The transfer of short term liquid funds abroad to earn a higher interest rate
Capitalising on the interest rate differences in another country
- uncovered interest arbitrage has the risk of possible depreciation of the foreign currency during the investment period
What is carry trade
Borrowing of low yielding currencies and lending in high yield inf currencies
What is covered interest arbitrage
- You are covered for the exchange rate risk
- force a relationship between forward rate premiums and interest rate differentials
How does covered arbitrage work
- spot rate = 90 day = $1.60
- US 90 day IR = 2%
- UK 90 day IR = 4%
Borrow $ at 3% or use the existing funds which are earning interest at 2%
Conger the dollar to pounds and engage in a 90 day forward contract to sell £ to $1.60/£ lend £ at 4%
- will not make profits instantaneously
What happens when you trigger arbitrage
Capitalising on the discrepancy will eliminate it and the forgiven exchange market will become orderly
What is interest rate parity
An equilibrium state is achieved when interest arbitrage is no longer feasible
- The difference between interest rates in any two countries is the same as the difference between the forward, and the sport rates of their respective currencies
-Plays in a central role in the foreign exchange market
What does interest rate parity cover
- A currency is worth, what it can earn
- The return on a currency is the interest rate on that currency, plus the expected rate of appreciation over a given period of
- When they return onto currencies, equal interest rate, parity prevails
-This does not mean that the interest rates are now the same just the returns on them
Explanation of the interest rate parity - 2 options
- invest in foreign currency locally at the risk free rate for a specific period of time that the proceeds into your domestic currency at maturity
- Or invest the same dollars in your domestic market for the same period of time, and where no arbitrage opportunities exist cash flows from both are equal
Violation of IRP
arbitrage opportunities exist
E.g . If the sport rate equals the forward rate, but interest rates were different:
– Investors would borrow in the currency with a lower rate
– Convert the cash at spot rates
-Enter into a Food contract, convert the cash, plus the expected interest rate at the same rate
-Invest the money at a higher rate
-Convert back through forward contract
- Repay the principle and the interest, knowing the latter will be less than the interest received
What are the implications of IRP
- If domestic IR are less than foreign you would invest in a foreign country at a higher interest rate and domestic investors can benefit by investing in the foreign market.
- If domestic rates are more than for an interest rate, you will invest in domestic market at higher interest rates, and for investors can benefit by investing in the domestic market
Look at derivation
Xxxxxx
What is PPP based
Based on trade and the exchange rate will adjust to offset inflation differences and holds for large differences
What is the IFE based on
Based on investment - investing in countries with higher interest rates is known as the carry trade x suggests that the exchange rate will change to offset any gains
Look at summary of emoercical evidence of parity conditions
Why is PPP and IRP important
Provide the markets best guess under the assumption of no expected profit given current prices
- these are assumptions for arbitrage instruments
Eliminated need to pay for pro analysis - few outperform market expectations
- simple framework to determine financial linkages between countries which affects capital markets
Why is country risk analysis important
Represents the potentially adverse impact of country Environment on forex returns
- countries risks are binary gov allowed or denies
Why may country risk analysis be used
To devise a risk management strategy appropriate to a country
– As a screening advice to avoid conducting business in countries with excessive risk
– To revise its investment of financing decisions, considering recent events
What do you need to consider when you look at a country risk?
- The attitudes of consumers in the host country
Some may be loyal to the locally manufactured products
– And the actions of the host government
They may want to impose special requirements or taxes, restrict fund transfers and subsidies local firms
Investors can also be hurt by a lack of restrictions, such as failure to enforce copyright laws
What other political risk factors are there to country risk
- blockage of fund transfer
- currency in convertibility
Foreign currency cannot be changed into other currencies. Therefore, the parent company may need to exchange earnings for goods. - war
- burecracy
- corruption
What are financial risk factors
- recession can reduce demand
-interest rates / exchange rates b inflation - country dependent on several financial factors
- recession can reduce demand
