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International arbitrage and interest rate parity

session 7
by

Pratik Singhi

on 13 January 2016

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Transcript of International arbitrage and interest rate parity

International Arbitrage and Interest Rate Parity Arbitrage is the act of capitalizing on a discrepancy in quoted prices by making a risk-less profit
Theoretically, it causes prices to realign 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
If the demand and supply conditions for a particular currency vary among banks, the banks may price that currency at different rates, and market forces will force realignment
with tech advancements, such opportunities are disappearing Locational Arbitrage Locational Arbitrage Cross exchange rates represent the relationship b/w two currencies different from home currency
Triangular arbitrage when currency transactions are conducted to capitalize on a discrepancy in the cross exchange rate between two currencies
If any two of these three exchange rates are known, the exchange rate of the third pair can be determined by cross calculation Triangular Arbitrage Triangular Arbitrage Interest arbitrage – process of capitalizing on difference between interest rates between two countries
Covered – Hedging your position against exchange rate risk with a forward contract Covered Interest Arbitrage Comparing arbitrage
strategies The forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between two currencies Interest Rate Parity
Where
Ah = Amount of home currency
S = Spot rate
if = Interest rate on foreign deposit
F = Forward rate
An = Amount of home currency received at the end of the deposit period Interest Rate Parity Rate of return

Forward Premium


Relationship between forward premium and interest rate differential Interest Rate Parity Interest Rate Parity If you have $10,000, how many dollars will you end up with if you implement this triangular arbitrage strategy Example
You have $800,000 to invest
Current GBP spot rate is $1.60
90-day forward rate of GBP is $1.60
90-day interest rate in US is 2%
90-day interest rate in UK is 4% You have $1,000,000 to invest
The current spot rate of the pound is $1.60
The 90-day forward rate of the pound is $1.60
The 90-day interest rate in the United States is 2%
The 90-day interest rate in the United Kingdom is 4%
What strategy would you follow? How much would you gain? Assume that as a result of covered interest arbitrage, the market forces caused the following
Spot rate of the pound to rise to $1.62 and
the 90-day forward rate of the pound declined to $1.5888
Consider the results from using $1,000,000 to engage in covered interest arbitrage Assume the following information:
Spot rate of £ /$1.60
180-day forward rate of £ /$1.56
180-day British interest rate 4%
180-day U.S. interest rate 3%
Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds)? Explain.
Does interest rate parity exist? Explain.
Assume that the British pound’s one-year forward rate exhibits a discount. Assume that interest rate parity continually exists. In such a case, explain how the discount on the British pound’s one-year forward discount would change if British one-year interest rates rose by 3 percentage points while U.S. one-year interest rates rose by 2 percentage points The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the United States is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero transaction costs.a. Does interest rate parity exist? b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage? Interest Rate Parity Triangular Arbitrage You go to a bank and are given these quotes:
You can buy 1 euro for 14 pesos or sell them for 13
You can buy 1 USD for 0.9 euros, or sell it for 0.8
You can buy 1 USD for 10 pesos, or sell it for 9

You have $1,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of transactions that you would execute and the profit that you would earn Triangular arbitrage As an employee of the foreign exchange department for a large company, you have been given the following information at the beginning of the year:
Spot rate of £ $1.596
Spot rate of Australian dollar (A$) $.70
Cross exchange rate: £1 A$2.28
One-year forward rate of A$ $.71
One-year forward rate of £ $1.58004
One-year U.S. interest rate 8.00%
One-year British interest rate 9.09%
One-year Australian interest rate 7.00%
Is triangular arbitrage feasible? If yes, how it should be conducted to make a profit Assume that the Mexican peso exhibits a 6-month interest rate of 6%, while the USD exhibits a 6-month interest rate of 5%. The peso’s spot rate is $0.10. Determine a U.S. investor’s return from using covered interest arbitrage.
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