1. International Arbitrage and Interest Rate Parity
CHAPTER 7
International Arbitrage
and Interest Rate Parity
© 2000 South-Western College Publishing 1

2. Chapter Objectives
To explain the conditions that will result in various forms of international arbitrage, along with the realignments that will occur in response to the various forms of international arbitrage; and
To explain the concept of interest rate parity, and how it prevents arbitrage opportunities.

3. International Arbitrage
Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. Often, the funds invested are not tied up and no risk is involved.
Locational arbitrage is possible when the bid price of one bank is higher than the ask price of another bank for the same currency.
e.g Bank A Bank B
dollars -> pounds pounds -> dollars
$1.61 / £ $1.62 / £
In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly.

4. International Arbitrage
Triangular arbitrage is possible when a quoted cross exchange rate differs from that calculated using the appropriate spot rates.
e.g. Bank A Bank B Bank C
$ -> £ £ -> Canadian$ Canadian$ -> $
$1.60 / £ £ / C$ $0.81 / C$
Note: Calculated cross rate = £ / C$
In response to the imbalance in demand and supply resulting from such arbitrage activity, the prices will adjust very quickly.

5. International Arbitrage
Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate.
e.g. 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%.
In response to the imbalance in demand and supply resulting from such arbitrage activity, the rates will adjust very quickly.

6. International Arbitrage
Locational arbitrage ensures that quoted exchange rates are similar across banks in different locations.
Triangular arbitrage ensures that cross exchange rates are set properly.
Covered interest arbitrage ensures that forward exchange rates are set properly.
Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy. Arbitrage thus makes the foreign exchange market more orderly.

7. Interest Rate Parity
When market forces cause interest rates and exchange rates to be such that covered interest arbitrage is no longer feasible, the equilibrium state achieved is referred to as interest rate parity (IRP).
When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate available in the home country By simplifying and rearranging terms:
forward = (1 + home interest rate) _ 1
premium (1 + foreign interest rate)

8. Interest Rate Parity If the 6-month Mexican peso interest rate = 6% ,
6-month U.S. dollar interest rate = 5% ,
then from the U.S. investor’s perspective,
forward = ( ) _ 1 = _ .9434%
premium ( ) (not annualized)
If the peso’s spot rate is $.10/peso,
then the 6-month forward rate
= spot rate x (1 + premium)
= .10 x (1 _ ) = $.09906/peso

9. Interest Rate Parity
The relationship between the forward rate and the interest rate differential can be simplified and approximated as follows:
forward = forward rate - spot rate
premium spot rate
» home _ foreign
interest rate interest rate
This approximated form provides a reasonable estimate when the interest rate differential is small.

10. Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate - foreign interest rate
Forward
Premium (%)
Discount (%)
- 2
- 4 2 4 1 3
- 1
- 3
IRP line

11. Graphic Analysis of Interest Rate Parity
Home Interest Rate - Foreign Interest Rate (%)
Forward
Premium (%)
Discount (%)
- 2
- 4 2 4 1 3
- 3
- 1
IRP line
Zone of potential covered interest arbitrage by foreign investors
Zone of potential covered interest arbitrage by local investors
Zone where covered interest arbitrage is not feasible

12. Interest Rate Parity
IRP generally holds. Where it does not hold, covered interest arbitrage may still not be worthwhile due to transaction costs, currency restrictions, differential tax laws, political risk, etc.
When IRP exists, it does not mean that both local and foreign investors will earn the same returns.
What it means is that investors cannot use covered interest arbitrage to achieve higher returns than those achievable in their respective home countries.

13. Correlation Between Spot and Forward Rates
Interest Rates iA
iU.S.
time
Forward Rates
Spot and
SpotA
ForwardA.
Because of interest rate parity, a forward rate will normally move in tandem with the spot rate. This correlation depends on interest rate movements.

14. Impact of Arbitrage on an MNC’s Value
Forces of Arbitrage
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent

15. Chapter Review International Arbitrage Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Comparison of Arbitrage Effects

16. Chapter Review Interest Rate Parity Derivation of Interest Rate Parity
Numerical Example
Graphic Analysis of Interest Rate Parity
Interpretation of Interest Rate Parity
Considerations When Assessing Interest Rate Parity
Correlation Between Spot and Forward Rates
Impact of Arbitrage on an MNC’s Value