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Corporate Finance presentation
Transcript of Corporate Finance presentation
Gabbyta Anandri Introduction
1. Concept of CIP
2. Data & Analysis
3. Empirical Evidence
4. Conclusion CIP example
consider two similar investment alternatives which only differ in terms of the currency. Initial fund: $100
Time: 1 year
Domestic currency: USD
Foreign currency: EUR 1. Invest home (USD)
Initial fund: $100
Time: 1 year
r: 4% Difference between 2 investments :
USD 104 - USD 101.48 = USD 2.52
CIP : application of Law of One Price
2 identical investments should have the same yield
i.e. Domestic investment = The covered foreign investment
(1+r) = F/S (1+r*)
if not equal, chance of arbitrage Further Analysis Data: only considers the most active period of market activity
Limit the use of stale quotes
Stale quote: may not be actually tradable
exclude weekends and days with unusually
low or no trading activities
(stringent condition) Akram, O., F., Rime, D., Sarno, L., (2008) Arbitrage in the Foreign Exchange Market:
Turning on the Microscope. Journal of International Economics, 78, 237-253 real-time evidence in the foreign exchange market.
deviations investigation from the covered interest rate parity (CIP) condition and foreign exchange markets
The analysis unveils that:
i) short-lived violations of CIP arise;
ii) the size of CIP violations can be economically significant;
iii) their duration is, on average, high enough to exploit them, but low enough to explain why such opportunities have gone undetected where the superscripts a and b symbolize ask and bid rates, respectively. Taking into account ask-bid spreads of interest rates and exchange rates, CIP arbitrage is not profitable under the following conditions: However,
(1+r) = F/S (1+r*) ignores transaction costs Such costs may be largely captured by the market buying (ask)
and selling (bid) quotes of interest rates and exchange rates
During volatile trading times, the bid-ask spread can also fluctuate greatly. On a trading platform, there are two prices quoted,
the higher price and the lower price
Broker keep the difference between those prices
This means that traders prefer to have low spreads Arbitrage Paradox The absence of arbitrage opportunities gives rise to ‘arbitrage paradox’
Grossman and Stiglitz (1976,1980) Further analysis profitable CIP deviations arise
small, yet non-negligible profits
requires currency volumes available for trading at quotes suggesting profitable arbitrage opportunities
Spot market: can estimate orders available for trade (limit orders) CIP arbitrage opportunities by day of week Limit Orders Buy/ Sell currency at a certain limit
1) tell them the amount you want to transfer and
2) the amount you want to receive in the new currency
3) the minimum amount you are happy to receive in new currency
Limit bid: Buy amount x at price < p, eventually
Limit ask: Sell amount x at price > p, eventually
Can place 2 Limit Orders at the same time :
Take a profit & Stop a loss CIP arbitrage opportunities by hour of day Day of the week and hours of the days effects Limit Orders Limit Orders : indicate liquidity in the spot currency market
More limit orders, more volume is available for trading
Indication of how liquidity providers behave
-Trading day from 07:00 to 18:00 GMT
-Not indicate obvious clustering at a particular time of the day
-However, appear more frequent in the middle of the trading day
-Results suggest that arbitrage opportunities
-May occur at any time and cannot be easily The role of market pace and volatility Illustrative evidence on whether frequency, size and duration of profitable arbitrage opportunities with
1.The pace of the market
2.Market volatility Conclusion Evidence in favor of the view that prices for spot
Money market instruments are set directly
Frequency, size and duration of apparent arbitrage opportunities decline
Grossman-Stiglitz view of financial markets
Efficiency is not interpreted
But the notion that in efficiently-functioning financial markets
Very short-term arbitrage opportunities can arise Market is active when CIP deviations are profitable Global financial crisis in 2007:
substantial deviations from CIP
Bankruptcy of Lehman Brothers
USD r : very low as compared to CIP condition
became the lowest in Tokyo market during most of the period
CIP between USD and EUR : hundreds of basis points Results Characteristics of CIP arbitrage violations tend to vary with the pace of the market
Frequency, size and duration are positively related both to IQ
Suggests that when markets are particularly active
-a high number of new quotes per unit of time
-the degree of uncertainty is relatively more stable
-Fewer arbitrage opportunities
-Smaller arbitrage proﬁt
-More short lived arbitrage opportunities Reasons for the deviations from CIP 1. Transaction Costs
(CIP usually holds after taking (1) into account)
2. Capital Control
3. Assets not sharing the same perception
of risk Data Collected via a continuous feed from Reuters over the period from February 13 to September 30 2004.
USD/EUR, USD/GBP and JPY/USD
Ask and bid quotes for the exchange rate swaps for the four maturities as well as for euro-currency deposits for the currencies involved. Using deposit rates for interest rates Advantage An arbitrageur would know when and how much she will pay or receive.
The use of deposits implies, however, that we limit the pool of potential arbitrageurs to those that have credit agreements since deposits are on balance sheet instruments System For spot exchange rates:
ﬁrm quotes from Reuters electronic brokerage system (D3000-2)
For swaps and euro-currency deposits:
Reuters Monitor (i.e. Reuters 3000 Xtra) However, spreads between indicative ask and bid quotes for swaps as well as for interest rates will not be smaller than those for corresponding ﬁrm ask and bid quotes.
Thus, use of the indicative quotes would probably not lead us to exaggerate the number and size of arbitrage opportunities. Actually, we may obtain results quite close to those implied by (unavailable) ﬁrm quotes for swaps and euro-currency deposits
In contrast, indicative quotes for spot are primarily meant as advertisement towards the non-bank customers .
Do not give a reliable indication of ﬁrm inter-dealer spot quotes.
It is more important to have ﬁrm quotes for spot exchange rates than for exchange rate swaps and euro-currency deposits to obtain results close to those implied by ﬁrm quotes for all instruments Drawback of using the indicative quotes They can become stale at times, and thereby potentially signal spurious arbitrage opportunities dealers keep real quotes up to date, but may fail to do so when market activity is particularly high,then,indicative quotes will be cantered on previous.
Then,it will be possible for the indicative ask to be lower than the true ask, or for the indicative bid to exceed the true bid, even while the indicative spread exceeds the true spread. Constraints on ‘fresh’ Merged all instruments according to date and time to the second into a ﬁle and then ﬁlled in missing ask and bid quotes for an instrument by using the latest quotes for that instrument.
Excluded weekends and days, left 151 trading days Frequency and size Table 2
Mean return- period return-negative- CIP arbitrage is loss-making.
Median- are very close to the mean returns
-indicating a fairly symmetric distribution.
t-values- the losses are statistically significant at conventional levels of significance inter-quote time Definition: the average time between two consecutive CIP deviations
The pace of the market
At least one of the quotes involved in a CIP deviation formula must change in order to define a new CIP deviation
Table2-very fast - especially at the higher maturities
New CIP deviations occur every 2–3 s on average for EUR and GBP, and every 6–7 s for JPY. “Pa dev” Reports the number of profitable arbitrage opportunities out of the total number of data points available (“All dev.”),
Calculated for each of the exchange rates and maturities considered.
A CIP arbitrage opportunity may on average arrive at least every hour when the number of profitable deviations(“Pa dev.”) are greater than 1661 (=151×11) As shares of the total number of data points considered,
however, the profitablearbitrage opportunities are very small. Duration (table 3) Sample standard deviations of the durations reveal large variations in the duration of proﬁtable CIP deviations
The standard deviations are quite different across the cases examined: they are mostly lower than a few minutes, but exceptionally they can be higher than 10 min.
They also explain the particularly long average duration of a few clusters of proﬁtable CIP deviations To exploit an arbitrage opportunity, however, a trader needs to undertake three deals virtually simultaneously or as fast as possible
Otherwise lead to a risk.
Reuters electronic trading system provides easy access to money and currency markets from one platform, allows a trader to undertake almost several deals with counterparts at the same time. Reuters electronic trading system Easy access to money and currency markets from one platform, allows a trader to undertake almost simultaneously several deals with counterparts.
Alternatively, virtually simultaneous trading in the money markets and the swap markets can be accomplished through tight cooperation between money market dealers and swap market dealers which seems to exist in a typical dealing room. Median values of the durations are even lower than the corresponding average durations <1 min in the case of EUR Most of average duration falls in the range from 30 s ~4 min. Cluster-consisting of at least two proﬁtable CIP deviations in a row-8~923 Table 3 reports summary statistics of the durations of clusters (sequences) of proﬁtable CIP deviations. Day of the Week and Hours of the Day Eﬀects One-way arbitrage opportunities
The existence of
OA and BA violations occur during a speciﬁc time of the day
Occur more frequently in some days of the week than others S: USD 1.22/EUR
F: USD 1.209/EUR
US interest rate (r): 4%
EUR interest rate (r*): 2.4% (Assume the interest rates are from the same place and time and carry the same risk and we ignore the transaction costs) 2. Invest abroad
(USD -> EUR -> USD)
Initial fund: $100
Time: 1 year
S: USD 1.22/EUR
F: USD 1. 209/ EUR
convert USD -> EUR
USD100/ (1 +S) Invest in EUR
= USD100/(1+S) * (1+r*)
= EUR 83.9344
Convert back to USD
= EUR 83.9344 * USD1.209/EUR
= $101.48 = $100 * (1+4%)
= $104 In Practice Several Studies on the deviations from CIP
under financial crisis Baba and Packer (2009) :
Creditworthiness of European
and US financial institutions
deviations from CIP
Coffey, Hrung and Sarkar ( 2009):
Explanations for CIP deviation:
Liquidity & Market Risk References Akram, O., F., Rime, D., Sarno, L., (2008) Arbitrage in the Foreign Exchange Market: Turning on the Microscope. Journal of International Economics, 78, 237-253. [online]
Available at: http://www.cass.city.ac.uk/__data/assets/pdf_file/0009/40689/JIE_2008.pdf
(Accessed 8 Mar 2013)
Fukada, S. 2011. Regional Liquidity Risk and Covered Interest Parity during the Glocal Financial Crisis: Evidence from Tokyo, London and New York. The University of Tokyo. [online] Available at: http://faculty.washington.edu/karyiu/confer/sea12/papers/SG12-103%20Fukuda.pdf
(Accessed 12 Mar 2013)
Moosa, I. 2009. International Finance: an nalytical approach[e-book]Oct. Australia: Mcgraw-Hill http://highered.mcgrawhill.com/sites/dl/free/0070278512/786726/Moosa_3e_CH11.pdf (Accessed 10 Mar 2013)
Sjo, B.2012. Covered and Uncovered Interest Parity [online] Available at: https://www.iei.liu.se/nek/730g82/memos/1.406470/CIParbitrage2012.pdf
(Accessed 8 Mar 2013) Frequency, size, no. of limit orders : small profits for a few pips/ arbitrage --> yield sizable profit