Chapter 7

International Arbitrage
and Interest Rate Parity
 International Arbitrage

• Arbitrage can be loosely defined as capitalizing on a

discrepancy in quoted prices by making a riskless profit.
• Locational arbitrage:
– Buying a currency at a location where it is priced
cheap and then immediately selling it at some other
location where it is priced higher.
– Gain is based on two factors:
 The amount of money used to capitalize on the exchange
rate discrepancy
 The size of discrepancy
– Quoted prices will react to the locational arbitrage
strategy used by you and other foreign exchange
market participants (realignment).
International Arbitrage
 International Arbitrage

• Triangular arbitrage:
– Currency transactions are conducted in the spot
market to capitalize on a discrepancy in the cross
exchange rate between two currencies.
– Accounting for the bid/ask spread
– Realignment
International Arbitrage
International Arbitrage
 International Arbitrage

• Covered interest arbitrage:

– Capitalizing on the difference in interest rates
between two countries while covering your
exchange rate risk with a forward contract.
– Realignment is focused on forward rate.
– Accounting for spreads
International Arbitrage
International Arbitrage
• Comparison of arbitrage effects:
 Interest Rate Parity

• When market forces cause interest rates and

exchange rates to adjust such that covered interest
arbitrage is no longer feasible, the result is an
equilibrium state known as interest rate parity (IRP).
• In equilibrium, the forward rate differs from the spot
rate by a sufficient amount to offset the interest rate
differential between two currencies.
 Interest Rate Parity

• Return from covered interest rate arbitrage:

• Forward premium:

• Approximation:
Interest Rate Parity
 Interest Rate Parity

• Considerations when assessing interest rate parity:

– Transaction Costs
– Political Risk
– Differential Tax Laws
Interest Rate Parity
 Variation in
Forward Premiums

• Forward premiums across maturities

• Changes in forward premiums over time