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International Arbitrage

Arbitrage refers to capitalizing on discrepancy in exchange rates. International arbitrage takes three common forms: Locational arbitrage Triangular arbitrage Covered interest arbitrage Locational arbitrage implies capitalizing on the differential exchange rates between locations.
Illustration
British pound quote

Bank A Bid Ask $1.59 $1.60

Bank B
Bid $1.61 Ask $1.62

International Arbitrage
Locational arbitrage Illustration
Bank A Bid Ask British pound quote $1.60 $1.61 Bank B Bid Ask $1.61 $1.62

Triangular arbitrage can be used whereby currency


transactions are conducted in the spot market to capitalize on a discrepancy in the cross exchange rate between two currencies.

Triangular arbitrage
A bank has quoted the British pound () at $2.00, the French franc (FF) at $.20 and the cross exchange rate at 1= FF 11.Based on these exchange rates can triangular arbitrage be used to earn a profit? Suppose you have $10,000 to invest. Firstly determine the number of pounds received for your dollars: 10,000 = 5000 based on banks quote of $2.00 per pound Second, determine how many francs you will receive in exchange for pounds: 5,000 = FF 55,000, based on the banks quote of 11 francs per pound. Finally, determine how many USD you will receive in exchange for the francs: FF55,000 = $11,000, based on banks quote of $.20 per franc. The triangular-arbitrage generates $11,000, which is $1,000 more than you started with.

Covered Interest Arbitrage


Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward rate premium or discount. It involves investing in a foreign country and covering against exchange rate risk. Example You have $1,000,000 to invest. The current spot rate of the pound is $2.00. The 90-day forward rate of the pound is $2.00. The 90-day interest rate in us is 2 percent. The 90-day interest rate in Great Britain is 4 percent.

Realignment Due To Covered Interest Arbitrage

1. Use USD to purchase pounds in the spot market 2. Engage in a forward contract to sell pounds forward. 3. Invest funds from the US in Great Britain

1. Upward pressure on the spot rate of pound. 2. Downward pressure on the forward rate of the pound.
3. Possible upward pressure on US interest rates and downward pressure on the British interest rates

Realignment Due To Covered Interest Arbitrage


Original Value after being Value affected by CIA 1.British pound spot rate in US $2.00 $2.01 dollars 2. British pound 90-day forward Rate in US dollars 2.00 1.99 3. US interest rate for 90 days 2% 2.47% 4. British interest rate for 90 days 4% 3.50%

Problems on Arbitrage
1.Assume that the following spot exchange rate exist today: DM = $.60 FF = $.15 DM = FF4 Assume no transaction costs. Based on these exchange rates, can triangular arbitrage be used to earn a profit? Explain.
2. Assume the following information: Spot rate for sterling pound = $1.60 180-day forward rate = $1.56 180-day British interest rate =4% 180-day U.S. interest rate = 3% Based on this information, is covered interest arbitrage feasible? Explain.

Problems on Arbitrage

3.

Assuming no transaction costs, suppose 1 = $2.4110 in New York, $1 = FF 3.997 in Paris, and FF1 = 0.1088 in London. How could you take profitable advantage of these rates?
Here are some prices in the international money markets: Spot rate = $0.75/DM, Forward rate (one year) = $0.77/DM Interest rate (DM) = 7% p.a., Interest rate ($) =9% p.a. Assuming no transactions costs or taxes exist, do covered arbitrage profits exists for US investors in the above situation? Describe the flows. Suppose now that transaction costs in the forex market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still exist?

4.

a.

b.

Problems on Arbitrage
5. Suppose the interest rate on pounds sterling is 12% in London and the interest rate in New York is 7%. The pound spot rate is $1.75 and the one year forward rate is $1.68. Is covered interest arbitrage feasible?
1. 2. 3. Borrow $1,000,000 in New York at an interest rate of 7%. This means that at the end of arbitrageur must repay principal plus interest of $1,070,000. Immediately convert the $1,000,000 to pounds at the spot rate of 1 = $1.75. This yields 571,428.57 available for investment. Invest the principal of 571,428.57 in London @12% for one year. At the end of the year, the arbitrageur will have 6,40,000. Simultaneously sign a forward contract at a rate of 1 = $1.68 for one year. At the end of the year, collect 6,40,000, get it converted into $1,075,200 and use $1,070,000 to repay the loan. The arbitrageur will earn $5,200 on this set of transactions.

4. 5.

Problems on Arbitrage
6. Assume the following information Bank X Bank Y Bid price for Swiss francs $.401 $.398 Ask price for Swiss francs $.404 $.400 Given this information, is locational arbitrage possible? If so, explain the steps that would reflect locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. 7. Assume the following information for a particular bank: Quoted Price Value of Canadian dollar in US dollars $.90 Value of German mark in US dollars $.30 Value of Canadian dollar in German mark DM 3.02 Given this information, is locational arbitrage possible? If so, explain the steps that would reflect locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use.

Problems on Arbitrage
8. Assume the following information: Spot rate of Canadian dollar = $.80 90-day forward rate of Canadian dollar= $.79 90-day Canadian interest rate = 4% 90-day US interest rate = 2.5% Given this information what would be the yield (% return) to a US investor who used covered interest arbitrage? (Assume the investor invests $ 1,000,000.)

Problems on Arbitrage
9. Assume the following information: Spot rate of French franc = $.100 180-day forward rate for French franc = $.098 180-day French interest rate = 6% 180-day US interest rate = 5% Given this information, is covered interest arbitrage worthwhile for French investors? (Assume the investor invests $ 1,000,000.)

Relationship Between Forward Rate Premium (or Discount) & The Interest Rate Differential
F S p ih i f S where p forward premium F forwarda rate in dollars S spot rate in dollars ih hom e int erest rate i f foreign int erest rate

Graphic Analysis of Interst Rate Parity


6 4
ih-if(%)

2 0 -6 -4 -2 -2 0 -4 -6 Forward Discount/Premium 2 4 6