Unit III International Arbitrage

7/29/2019 Unit III International Arbitrage

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International Arbitrage

Arbitrage refers to capitalizing on discrepancy in exchangerates.

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 Bank A Bank B

Bid Ask Bid Ask

British pound quote $1.59 $1.60 $1.61 $1.62


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International Arbitrage

Locational arbitrage

Illustration

Bank A Bank BBid Ask Bid Ask

British pound quote $1.60 $1.61 $1.61 $1.62

Triangular arbitragecan be used whereby currencytransactions are conducted in the spot market to capitalizeon a discrepancy in the cross exchange rate between twocurrencies.


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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 theseexchange 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 forpounds: 5,000 = FF 55,000, based on the banks quote of 11 francs perpound.

Finally, determine how many USD you will receive in exchange forthe francs: FF55,000 = $11,000, based on banks quote of $.20 perfranc. The triangular-arbitrage generates $11,000, which is $1,000more than you started with.


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Covered Interest Arbitrage

Covered interest arbitrage tends to force a relationshipbetween the interest rates of two countries and theirforward 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.


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Realignment Due To Covered Interest Arbitrage

1. Use USD to purchase

pounds in the spot

market2. 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


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Realignment Due To Covered Interest Arbitrage

Original Value after being

Value affected by CIA

1.British pound spot rate in US $2.00 $2.01dollars

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%


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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 triangulararbitrage be used to earn a profit? Explain.

2. Assume the following information:

Spot rate for sterling pound = $1.60

180-day forward rate = $1.56180-day British interest rate =4%

180-day U.S. interest rate = 3%

Based on this information, is covered interest arbitrage feasible? Explain.


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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 couldyou take profitable advantage of these rates?

4. 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.

a. Assuming no transactions costs or taxes exist, do covered arbitrageprofits exists for US investors in the above situation? Describe the

flows.b. Suppose now that transaction costs in the forex market equal 0.25%

per transaction. Do unexploited covered arbitrage profitopportunities still exist?


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5.Suppose the interest rate on pounds sterling is 12% in London and theinterest rate in New York is 7%. The pound spot rate is $1.75 andthe one year forward rate is $1.68. Is covered interest arbitrage

feasible?1. Borrow $1,000,000 in New York at an interest rate of 7%. This means thatat the end of arbitrageur must repay principal plus interest of $1,070,000.

2. Immediately convert the $1,000,000 to pounds at the spot rate of 1 =$1.75. This yields 571,428.57 available for investment.

3. Invest the principal of 571,428.57 in London @12% for one year. At the

end of the year, the arbitrageur will have 6,40,000.4. Simultaneously sign a forward contract at a rate of 1 = $1.68 for one year.

5. At the end of the year, collect 6,40,000, get it converted into $1,075,200and use $1,070,000 to repay the loan. The arbitrageur will earn $5,200 onthis set of transactions.


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6. Assume the following informationBank 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 stepsthat would reflect locational arbitrage, and compute the profit from thisarbitrage 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 stepsthat would reflect locational arbitrage, and compute the profit from thisarbitrage if you had $1,000,000 to use.


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Spot rate of Canadian dollar = $.80

90-day forward rate of Canadian dollar= $.7990-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 coveredinterest arbitrage? (Assume the investor invests$ 1,000,000.)


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Spot rate of French franc = $.100

180-day forward rate for French franc = $.098180-day French interest rate = 6%

180-day US interest rate = 5%

Given this information, is covered interest arbitrageworthwhile for French investors? (Assume the

investor invests $ 1,000,000.)


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Relationship Between Forward Rate Premium (or

Discount) & The Interest Rate Differential

hom int

int

h f

h

f

F Sp i i

S

wherep forward premium

F forwarda rate in dollars

S spot rate in dollarsi e erest rate

i foreign erest rate


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Graphic Analysis of Interst Rate Parity

-6

-4

-2

0

2

4

6

-6 -4 -2 0 2 4 6

Forward Discount/Premium

ih-if(%

)

Unit III International Arbitrage

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