Topic 12 - Arbitrage

• Interest arbitrage


  Capitalizing on a discrepancy in quoted prices to make a riskless profit
• Effect of arbitrage

  • Causes prices to realign, such that no further risk-free profits can be made
• Forms of international arbitrage


  • Locational arbitrage
  • Triangular arbitrage
  • Covered interest arbitrage
• Locational arbitrage

  Possible when a bank's buying price (bid price) is higher than another bank's selling price (ask price) for the same currency
• Triangular arbitrage

  Possible when a cross exchange rate quote differs from the rate calculated from spot rate quotes
• Triangular arbitrage example


  • Buy £ @ $1.61, convert @ MYR8.10/£, then sell MYR @ $0.200. Profit = $0.01/£
• Uncovered interest arbitrage

  Transfer of short-term liquid funds abroad to earn a higher rate of return, entailing foreign exchange risk due to possible depreciation of the foreign currency
• Covered interest arbitrage

  Spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale of the foreign currency to cover, or remove, the foreign exchange risk
• Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials
• Covered interest arbitrage example


  • Borrow $ at 3% or use existing funds which are earning interest at 2%. Convert $ to £ at $1.60/£ and engage in a 90-day forward contract to sell £ at $1.60/£. Lend £ at 4%.
• Comparing arbitrage strategies


  • Locational: capitalizes on discrepancies in arbitrage exchange rates across locations
  • Triangular: capitalizes on discrepancies in arbitrage cross-exchange rates
  • Covered: capitalizes on discrepancies interest between the forward rate and the arbitrage interest rate differential
• Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy, thus making the foreign exchange market more orderly
• Interest rate parity (IRP)


  As a result of market forces, the forward rate differs from the spot rate by an amount that sufficiently offsets the interest rate differential between two currencies
• Interest rate parity - 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
• When the returns on two currencies are equal, interest rate parity prevails
• Violation of IRP

  An arbitrage opportunity exists if the forward rate is the same as the spot rate, but the interest rates are different
• If domestic interest rates are less than foreign interest rates

  Domestic investors can benefit by investing in the foreign market
• If domestic interest rates are more than foreign interest rates

  Foreign investors can benefit by investing in the domestic market
• Derivation of IRP

  The rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country
• Determining the forward premium

  Forward premium = (1+home interest rate)/(1+foreign interest rate) - 1
• Empirical studies indicate that IRP generally holds, but there are deviations often not large enough to make covered interest arbitrage worthwhile
• Considerations when assessing IRP


  • Political risk
  • Differential tax laws
• Carry trade

  Borrowing of funds in low-yielding currencies and lending in high-yielding currencies
• Carry trade opportunities are short-lived as arbitrage activities quickly restore interest rate parity
• Efficiency of foreign exchange markets

  Markets are efficient if forward rates accurately predict future spot rates
• Eurocurrency


  Commercial bank deposits outside the country of their issue
• Examples of Eurocurrency


  • Eurodollar
  • Eurosterling
  • Eurodeposit
• Eurocurrency market

  The market in which the borrowing and lending of Eurocurrency balances takes place
• Reasons for offshore deposits include higher interest rates on short term deposits abroad compared to domestic rates, and convenience for international corporations to hold balances abroad in needed currencies
• Efficiency of Foreign Exchange Markets

  • Markets are efficient if prices reflect all possible information
  • The foreign exchange market is efficient if forward rates accurately predict future spot rates
• Empirical evidence on the efficiency of foreign exchange markets is mixed
• Eurocurrency


  • Eurodollar
  • Eurosterling
  • Eurodeposit
• Reasons for Offshore Deposits

  • Interest rates on short term deposits abroad are often higher than domestic rates
  • International corporations often find it convenient to hold balances abroad for short periods in currency they need for payments
  • International corporations can overcome domestic credit restrictions by borrowing in the Eurocurrency market
• Eurobonds

  Long-term debt securities sold outside the borrower's country to raise long-term capital in a currency other than the currency of the nation where the bonds are sold
• Euronotes

  Medium-term financial instruments used by corporations, banks and countries to borrow medium-term funds in a currency other than the currency in which the notes are sold
• Purchasing Power Parity (PPP) does not necessarily hold
• Investors have limited information on corporate exposure but can make approximate estimates of the effect of exchange rate changes on share value
• MNC shareholders can hedge against exchange rate fluctuations on their own
• A well-diversified MNC should not be affected by exchange rate movements because of offsetting effects, but this is a naive presumption as few are that well diversified