Chapter 4. AbitrageandIRP PDF

CHAPTER 4
INTERNATIONAL ARBITRAGE
AND INTEREST RATE PARITY
LEARNING OUTCOMES
This chapter will:

A. Explain the conditions that will result in
various forms of international arbitrage and the
realignments that will occur in response
B. Explain the concept of interest rate parity
INTERNATIONAL ARBITRAGE
Defined as capitalizing on a discrepancy in quoted

prices by making a riskless profit
CLASSIFICATION OF ARBITRAGE
Locational Arbitrage
Triangular Arbitrage
Covered interest arbitrage

LOCATIONAL ARBITRAGE
Defined as the 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.
Example:
North Bank Bid Ask South Bank Bid

Ask
NZ$ $.635 $.640 NZ$ $.645
$.650
Akron Bank Zyn Bank
Bid Ask Bid Ask
£ quote $1,60 $1,61 £ quote $1,61 $1,62

When I see this opportunity, you also see, there

are a lot people do buying and selling like this,
the market will be adjust as following.
$NZ
$NZdemand
demandof of $NZ
$NZ become
become North
Northbank
bank
North
Northbank
bank scarce increase
increasethe
the
increase
scarce $NZ
increase $NZaskaskprice
price
$NZ
$NZsupply
supplyof
of South
Southbank
bank
South
South bank
bank decrease
decreasethe
the
increase
increase $NZ
$NZbid
bidprice
price
Gains
Gains of
of locational
locational
arbitrage
arbitrage decrease
decrease
TRIANGULAR ARBITRAGE
Defined as currency transactions in the spot market

to capitalize on discrepancies in the cross exchange
rates between two currencies.
Example: Bid Ask

British pound (£) $1.60 $1.61
Malaysian ringgit (MYR) $.200 $.202
£ MYR8.1 MYR8.2
Assume investor have 10.000 USD to invest
1. GBP/MYR = 8.1-8.2 (quotation at bank)

2. comparation: GBP/MYR= 7.92-8,05 (calculation)
Condition : When Quoted Bid cross rate is higher
Calculated Ask cross rate.
3. Do arbitrage with the higher value currency (bank
quotation).
3. 1 GBP= 8.05 MYR

But Bank buy 1 GBP= 8.1 MYR
ÞGBP is higher quoted currency
TRIANGULAR ARBITRAGE (*)
TRIANGULAR ARBITRAGE (ADD TRUE)
Activity Impact
Participants use dollars to Bank increases its ask price of
purchase pounds. pounds with respect to the dollar
Participants use pounds to Bank reduces its bid price of the

purchase Malaysian ringgit. British pound with respect to the
ringgit; that is, it reduces the
number of ringgit to be
exchanged per
pound received.
Participants use Malaysian ringgit Bank reduces its bid price of

to purchase U.S. dollars. ringgit with respect to the dollar
Bid Ask
British pound (£) $1,95 $2,00
US dollar VND 17.500 VND 18.000
£ VND 36.900 VND 37.200
Assume investor is initial with10.000 USD

COVERED INTEREST ARBITRAGE
Defined as the process of capitalizing on the

interest rate differential between two countries
while covering your exchange rate risk with a
forward contract.
The amount of money: 1,000,000,000 VND

SGD spot rate: SGD/VND= 13,605
SGD 90 days forward rate SGD/VND = 13,605
Vietnam 90 days rate: 2%
Singapore 90 days rate: 4%
Convert 1,000,000,000 VND

1 Sell 76.440 SGD
to 73.500 SGD and deposit
in Singapore bank
+ 90 days forward
By the time the deposit

2 matures, you will have
76.440 SGD (including interest).
Convert 76.440 SGD

3 into 1.040.000 VND based
on the forward contract rate
of SGD 0.0735/1000 VND
There is upward
1 Convert VND into
pressure on
SGD on spot market
SGD spot rate
There is downward
2 Engage in a forward
pressure on the
contract to sell SGD
90-day SGD forward rate
There is upward
3 VND invest into pressure on Viet Nam
Singapore and downward on
Singapore interest rate
INTEREST RATE PARITY- IRP
In equilibrium, the forward rate differs from the

spot rate by a sufficient amount to offset the
interest rate differential between two currencies.
F= S(1 + p)
Premium or Discount (p):
F > S  p > 0 : Premium

F
p  1
S
F < S  p < 0 : Discount
An investor act of CIA, so the amount of the home

currency received at the end of the deposit period due to
such a strategy
An = (Ah/S)(1+ if)F
Ah : The amount of the home currency that is initially invested

St : The spot rate of foreign currency
if : The interest rate on the foreign deposit
F : The forward rate
An: The amount of the home currency received at the end of the
deposit period due to such a strategy
An investor act of CIA, so the amount of the home

currency received at the end of the deposit period due to
such a strategy
An = (Ah/S)(1+ if)F
Ah : 1.000.000.000 VND
St : 13.605
if : 4%
F : 13.605
An: 1.040.000.000
Since F = S(1+ p), we can rewrite this equation as:


An = (Ah/S)(1+ if)[S(1+ p)] = Ah(1+ if)(1+ p)
The rate of return from this investment (called R) is as

follows
rf = (1+ if)(1+ p) – 1
If IRP exists, then the rate of return achieved from

covered interest arbitrage (rf) should be equal to the rate
available in the home country (ih)
rf = ih
(1+ if) (1+ p) – 1 = ih
By rearranging terms, we can determine what the forward

premium of the foreign currency should be under conditions
of IRP
1  ih
p -1
1 i f
Relationship between Forward Premium and Interest Rate

differential, IRP exists, CIA does not exist and vice versa
F- S
p = ih - if
S
p: forward premium (or discount)
F: forward rate of home currency
S: spot rate of home currency
ih: home interest rate
if: foreign interest rate
(if=0)
Example 1
VND 6 months interest rate is 4%, USD 6 months interest
rate is 2%
Spot rate: 19,000VND/USD. An investor initial 1 billions
VND
1  0,04
p - 1  0,01960  1,97%
1  0,02
F  S (1  p )  19000(1  0.0197)  19.3743

GRAPHIC ANALYSIS OF INTEREST RATE
PARITY
PARITY
 Points representing a discount: points A and B

 Points representing a premium: points C and D
 Points representing IRP: points A, B, C, D
PARITY
 Points representing a discount: points A and B

 Points representing a premium: points C and D
 Points representing IRP: points A, B, C, D
PARITY
 Points below the IRP line: points X and Y

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
U.S. investors would achieve a lower return on a
foreign investment than on a domestic one.
CONSIDERATIONS WHEN
ASSESSING INTEREST RATE
PARITY
 Transaction costs
 Political risk
 Differential tax laws

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CHAPTER 4

This chapter will:

Defined as capitalizing on a discrepancy in quoted

Covered interest arbitrage

Defined as the process of buying a currency at the

Gains from locational arbitrage are based on the

North Bank Bid Ask South Bank Bid

Akron Bank Zyn Bank

Bid Ask Bid Ask

£ quote $1,60 $1,61 £ quote $1,61 $1,62

When I see this opportunity, you also see, there

Defined as currency transactions in the spot market

Example: Bid Ask

1. GBP/MYR = 8.1-8.2 (quotation at bank)

3. 1 GBP= 8.05 MYR

Participants use pounds to Bank reduces its bid price of the

Participants use Malaysian ringgit Bank reduces its bid price of

British pound (£) $1,95 $2,00

US dollar VND 17.500 VND 18.000

£ VND 36.900 VND 37.200

Assume investor is initial with10.000 USD

Defined as the process of capitalizing on the

The amount of money: 1,000,000,000 VND

Convert 1,000,000,000 VND

By the time the deposit

Convert 76.440 SGD

In equilibrium, the forward rate differs from the

Premium or Discount (p):

F > S  p > 0 : Premium

An investor act of CIA, so the amount of the home

Ah : The amount of the home currency that is initially invested

An investor act of CIA, so the amount of the home

Since F = S(1+ p), we can rewrite this equation as:

The rate of return from this investment (called R) is as

If IRP exists, then the rate of return achieved from

By rearranging terms, we can determine what the forward

Relationship between Forward Premium and Interest Rate

F  S (1  p )  19000(1  0.0197)  19.3743

 Points representing a discount: points A and B

 Points representing a discount: points A and B

 Points below the IRP line: points X and Y

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