UNIVERSITY OF ECONOMICS AND LAW

FACULTY OF FINANCE AND BANKING

Chapter 5
International Arbitrage and Interest Rate Parity
I N T E R N AT I O N A L F I N A N C E

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International Arbitrage
Defined as capitalizing on a discrepancy in quoted prices by making a riskless
profit.
Arbitrage will cause prices to realign.
Three forms of arbitrage:
▪ Locational arbitrage
▪ Triangular arbitrage
▪ Covered interest arbitrage

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 Contents
1. Locational Arbitrage

2. Triangular Arbitrage

3. Covered Interest Arbitrage

4. Interest Rate Parity

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1. Locational Arbitrage
Defined as the 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.

Gains from locational arbitrage are based on the amount of money used and the
size of the discrepancy.

Realignment due to locational arbitrage drives prices to adjust in different

locations so as to eliminate discrepancies.

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 1. Locational Arbitrage

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1. Locational Arbitrage

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 2. Triangular Arbitrage
Defined as currency transactions in the spot market to capitalize on discrepancies
in the cross-exchange rates between two currencies.
Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce
or even eliminate the gains from triangular arbitrage.
Realignment due to triangular arbitrage forces exchange rates back into
equilibrium.

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2. Triangular Arbitrage
Example

Assume that a bank has quoted the British pound (£) at $1.60, the Malaysian
ringgit (MYR) at $0.20, and the cross-exchange rate at £1=MYR8.1.

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 2. Triangular Arbitrage
Example

Based on this information, you can engage in triangular arbitrage by:

1. purchasing pounds with dollars

2. converting the pounds to ringgit

3. exchanging the ringgit for dollars

If you have $10,000, then how many dollars will you end up with if you
implement this triangular arbitrage strategy?

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2. Triangular Arbitrage

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 2. Triangular Arbitrage

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3. Covered Interest Arbitrage

Defined as the process of capitalizing on the interest rate differential between two
countries while covering your exchange rate risk with a forward contract.
Consists of two parts:
1. Interest arbitrage: the process of capitalizing on the difference between
interest rates between two countries.
2. Covered: hedging the position against interest rate risk.

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 3. Covered Interest Arbitrage
Example

You desire to capitalize on the relatively high interest rates found in the United
Kingdom and have funds available for 90 days. The interest rate is certain; only
the future exchange rate at which you will exchange pounds back to U.S. dollars
is uncertain. You can use a forward sale of pounds to guarantee the rate at which
you can exchange pounds for dollars at some future time.

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3. Covered Interest Arbitrage

Example

Assume the following information:

▪ You have $800,000 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 percent.

▪ The 90-day interest rate in the United Kingdom is 4 percent.

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 3. Covered Interest Arbitrage
Based on this information, you should proceed as follows:

1. On day 1, convert the $800,000 to £…………., and deposit the £……………

in a British bank.

2. On day 1, sell £…………… 90 days forward. By the time the deposit matures,
you will have £…………… (including interest).

3. In 90 days, when the deposit matures, you can fulfill your forward contract
obligation by converting your £…………… into $...............

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3. Covered Interest Arbitrage

Accounting for spreads: Investor must account for the effects of the spread
between the bid and ask quotes and of the spread between deposit and loan
rates.

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 International Arbitrage
Comparison of Arbitrage Effects
1. The threat of locational arbitrage ensures that quoted exchange rates are
similar across banks in different locations.
2. The threat of triangular arbitrage ensures that cross exchange rates are
properly set.
3. The threat of covered interest arbitrage ensures that forward exchange rates
are properly set.
→ Arbitrage tends to allow for a more orderly foreign exchange market.
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International Arbitrage
How arbitrage reduces transaction costs

▪ Locational arbitrage limits the differences in a spot exchange rate quotation

across locations

▪ Covered interest arbitrage ensures that the forward rate is properly priced

→ An MNC’s managers should be able to avoid excessive transaction costs.

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 International Arbitrage

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4. Interest Rate Parity

In equilibrium, the forward rate differs from the spot rate by a sufficient amount
to offset the interest rate differential between two currencies.
𝐹 − 𝑆 1 + 𝑖ℎ
𝑝= = −1
𝑆 1 + 𝑖𝑓
p = forward premium (or discount)

F = forward rate in dollars S = spot rate in dollars

ih = home interest rate if = foreign interest rate

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 4. Interest Rate Parity
Example

Assume that the Mexican peso exhibits a six-month interest rate of 6 percent and
that the U.S. dollar exhibits a six-month interest rate of 5 percent. According to
IRP, the forward rate premium of the peso with respect to the U.S. dollar should
be:

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4. Interest Rate Parity

Example

If the peso’s spot rate is $0.10, then a forward discount of 0.94 percent results in
the following calculation of the six-month forward rate:

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 4. Interest Rate Parity
The relationship between the forward premium (or discount) and the interest rate
differential according to IRP is simplified in an approximated form:

Implications: If the forward premium is equal to the interest rate differential as

just described, then covered interest arbitrage will not be feasible.

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4. Interest Rate Parity

Example: Assume the investor begins with $1,000,000 to invest. Calculate the
number of U.S. dollars received from the conversion.

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 4. Interest Rate Parity

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4. Interest Rate Parity

▪ Points representing a discount: points A and B

▪ Points representing a premium: points C and D

▪ Points representing IRP: points A, B, C, D

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 4. Interest Rate Parity
▪ Points below the IRP line: points X and Y

Investors can engage in covered interest arbitrage and earn a higher return by
investing in foreign currency after considering foreign interest rate and
forward premium or discount.

▪ Points above the IRP line: point Z

U.S. investors would achieve a lower return on a foreign investment than on a

domestic one.

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4. Interest Rate Parity

Does Interest Rate Parity Hold?
Compare the forward rate (or discount) with interest rate quotations occurring
at the same time.
Due to limitations in access to data, it is difficult to obtain quotations that
reflect the same point in time.

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 4. Interest Rate Parity
Considerations When Assessing Interest Rate Parity

1. Transaction costs

2. Political risk

3. Differential tax laws

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4. Interest Rate Parity

1. Transaction costs

The actual point reflecting the interest rate differential and forward rate
premium must be farther from the IRP line to make covered interest arbitrage
worthwhile.

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 4. Interest Rate Parity

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4. Interest Rate Parity

2. Political risk

A crisis in the foreign country could cause its government to restrict any
exchange of the local currency for other currencies.

3. Differential tax laws

Covered interest arbitrage might be feasible when considering before-tax

returns but not necessarily when considering after-tax returns.

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