International Arbitrage and

Interest Rate Parity

The Law of One Price
• Law of one price postulates that identical goods or services must
always sell at the same price across markets or countries.
• For example let Pi be the price of commodity ,”i” expressed in
domestic currency and Pi * be the price of same commodity
expressed in foreign currency and E be the exchange rate (home
currency price of foreign currency).
• Law of One Price can be expressed as :
• P i = Pi * x E
• It implies exchange rate equalizes prices in two different markets
Ceteris-Peribus Conditions of Law of One
Price to hold
• No Transportation Costs
• No transaction costs
• No tariffs
• Under such costs/tariffs product cost would vary from country to country which may
give rise to arbitrage profit
• No restriction of movement of products
• in form of bans or quotas on export/import which may hamper price equalization
• Free flow of information
• No product differentiation (in terms of quality, quantity and appearance)
International Arbitrage
1. Defined as capitalizing on a discrepancy in quoted prices by making a riskless
profit.
2. Three forms of arbitrage:
a. Locational arbitrage
b. Triangular arbitrage
c. Covered interest arbitrage
Locational Arbitrage
1. 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.
2. Gains from locational arbitrage are based on the amount of money
used and the size of the discrepancy.
3. Realignment due to locational arbitrage drives prices to adjust in
different locations so as to eliminate discrepancies.
Example: Locational Arbitrage (without
bid/ask spread)
• Akron Bank is US bank and Zyn Bank is a British Bank and both serve
forex markets. Suppose there are no bid ask spreads. Exchange rate
quoted by Akron for British Pound is $1.60 while exchange rate
quoted by Zyn Bank is $1.61. How can you conduct locational
Arbitrage
Solution: Locational Arbitrage (without
bid/ask spread)
• Locational Arbitrage can be conducted by:
• Buying pounds at Akron Bank for $1.60 per pound
• Selling them at Zyn bank for $1.61 per pound
• Thus, making riskless profit of $0.01 per pound
• Locational arbitrage is normally conducted by banks or forex dealers
whose computers can quickly take benefit of arbitrage opportunity
• It vanishes quickly and retail investors have little chance to play in it.
Example: Locational Arbitrage (with bid/ask
spread)
• Suppose the Akron and Zyn bank have following bid-ask spreads:

• How would you create locational arbitrage?

Solution: Locational Arbitrage (with bid/ask
spread)
• Locational Arbitrage can be conducted by:
• Buying pounds at ask price of Akron Bank for $1.61 per pound
• Selling them at Zyn bank for $1.61 per pound
• You just break even
• Locational arbitrage is not possible even if the bid-ask spreads of two
banks are different
• To achieve profits from locational arbitrage, the bid price of one bank
must be higher than the ask price of other bank
• Note: your gain form locational arbitrage would depend upon the
amount of money used to capitalize on exchange rate discrepancy
Example: Locational Arbitrage (with bid/ask
spread)
• Suppose the Bank C and bank D have following bid-ask spreads:

Bank C Bank D
NZ$ Quote $0.635 $0.640 NZ$ Quote $0.645 $0.650

• If you start with USD 10,000.

• How would you create locational arbitrage?
Solution: Locational Arbitrage (with bid/ask
spread)
• Locational Arbitrage can be conducted by:
• Initially $10,000 are exchanged for NZ$ 15,625 ($10000/$0.640 per NZ$)at
Bank C
• Selling NZ$15,625 for 0.645 at Bank D for total amount of $10,078
• Locational Arbitrage Profit =$78
• This is called as one round-tripping
• Such round tripping can continue over telecommunication network
till arbitrage wiped out
• One can make huge profits with larger amount of money
Realignment due to locational Arbitrage
• Quoted price will react to locational arbitrage strategy used by you
and other forex participants
• Like in previous example:
• High Demand for $NZ in Bank C would cause shortage of NZ$, hence, bank C
will raise its ask price
• Excess supply of NZ$ at Bank D would force it to lower its bid price
• Once the ask and bid prices adjust at the two banks, locational
arbitrage opportunity would vanish
• Note: Prices may adjust within the seconds or minutes from time
when locational arbitrage occurred and it can happen within same
city, same country or different countries
Interbank Arbitrage
• Suppose, rates quoted by HDFC bank are: $1 = INR82.50/83.34
• Rates quoted by SBI = $1 = 81.10/82.30
Q. Is it possible to create a locational arbitrage?
Inverse Quotes and Two Point Arbitrage
• Suppose the rate quoted by SBI is: € 1 = INR 80.70/82.20
• Rates quoted by Deutsche Bank in Germany is:
INR1 = € 0.01203/ € 0.01211
• Is there any arbitrage opportunity available by converting INR to
pound?
Inverse Quotes and Two Point Arbitrage
• Solution:
• Rate quoted by SBI is: € 1 = INR 80.70/82.20
• To find arbitrage opportunity let us find inverse quote (Indirect
Quote) in Germany: € 1 = INR 82.52/83.10
• There is clearly an arbitrage opportunity available. An arbitrager can
buy € 1,00,000 from SBI @ 82.20 for a sum of INR 82,20,000 and
simultaneously selling them with Deutsche Bank @82.52 for INR
82,52,000.
• Thus, he makes riskless profit of INR 32000
Triangular Arbitrage
1. Defined as currency transactions in the spot market to capitalize on
discrepancies in the cross exchange rates between two currencies.
2. Cross Exchange Rate: represents the relationship between two
currencies that are different from one’s base currency
3. Accounting for the Bid/Ask Spread: Transaction costs (bid/ask
spread) can reduce or even eliminate the gains from triangular
arbitrage.
4. Realignment due to triangular arbitrage forces exchange rates back
into equilibrium.
Cross Exchange Rate
!"#$% &' ( )* $
• Value of Currency X in units of Currency Y =
!"#$% &' , )* $
• If British pound is worth $1.60 while Canadian$ (C$) is worth $0.80,
the value of British pound (£) with respect to Canadian$ is calculated
as:
• Value of £ in units of C$ = $1.60/$0.80 = 2.0
• Value of C$ in units of £ = $0.80/$1.60 = 0.50
• Note: Value of C$ in units of £ is simply the reciprocal of value of £ in
units of C$
Triangular Arbitrage: Example (without bid-ask
spread)
Q. Assume that a bank has quoted £ at $1.60, the Malaysian Ringgit
(MYR) at $0.20 and cross exchange rate at £1 = MYR8.10.
• Find out whether there is any possibility of arbitrage here if you have
$10,000 with you?
Triangular Arbitrage: Example (without bid-ask
spread)
Sol.
• Cross Rate as per theory £1 = $1.60/$0.20 = MYR 8.0.
• Cross rate given by bank £1 = MYR 8.1
• Hence, one can enter into triangular arbitrage with$10,000:
a. By buying £ with $
b. Converting £ into MYR
c. Buying $ with MYR
• $10,000 = £6,250 ($10000/$1.60)
• £6,250 = MYR 50,625 (6250*8.10)
• MYR 50,625 =$10,125 (50625*.20)
• Thus, triangular arbitrage results in a profit of $125
• Note: Like locational arbitrage triangular arbitrage also does not require tying up of funds
and strategy is risk-free.
Triangular Arbitrage: Example(with bid/ask
spread)
Q. Find out if triangular arbitrage possibility is there as per information
given in previous example with following bid-ask spread:
Particulars Quoted Bid Price Quoted Ask Price
Value of £ in $ $1.60 $1.61
Value of MYR in $ $0.200 $0.201
Value of £ in MYR MYR 8.10 MYR 8.20
Triangular Arbitrage: Example (with bid-ask spread)

Solution.
1. Converting $10,000 to £ = £6,211 (based on ask price of $1.61)
2. £6,211 to MYR = MYR 50,310 (bid price of 8.1 =6,211*8.1)
3. MYR50,310 to $ = $10,062 (bid price of$0.200)
• Net Profit = $62, which is less than previous example
Realignment due to Triangular Arbitrage
Activity
1. Participants use dollars to purchase pounds
2. Participants use £ to purchase MYR
3. Participants use MYR to purchase $
Impact
Bank increases its ask price of pounds with respect to$
Bank reduces its bid price of £ with respect to MYR i.e.
it reduces number of MYR to be exchanged per £
Bank reduces its bid price of MYR with respect to $

• Hence, triangular arbitrage will put exchange rates into equilibrium

Covered Interest Arbitrage
1. Defined as the process of capitalizing on the interest rate differential between
two countries while covering your exchange rate risk with a forward contract.
2. Consists of two parts:
a. Interest arbitrage: the process of capitalizing on the difference between interest rates
between two countries.
b. Covered: hedging the position against interest rate risk.
3. Covered interest arbitrage is sometimes interpreted to mean that funds to be
invested are borrowed locally
4. Realignment due to covered interest arbitrage causes market realignment.
5. Timing of realignment may require several transactions before realignment is
completed.
Covered Interest Arbitrage: Example
• You have US$ and you desire to capitalize on relatively higher interest
rates in UK and have funds available for 90 days. Interest rate is fixed
and only future exchange rate is uncertain. Try to find out possibility
of covered interest arbitrage with following numbers:
• You have $800,000
• Current Spot rate of £ is $1.60
• 90-day forward rate of £ is $1.60
• 90-day interest rate in US is 2%
• 90-day interest rate in UK is 4%
Covered Interest Arbitrage: Example
• The actual strategy to be followed would be:
1. On day1, convert $ to £, and set up 90 day deposit in UK bank
2. On day 1, engage in forward contract to sell £ 90 days forward
3. In 90 days when deposit matures, convert $ to £ at forward rate
• Solution
• Converting $800,000 to pounds = £500,000 (at spot rate of $1.60 per £)
• Deposit £500,000 in UK bank at 4% rate
• Simultaneously set up forward contract to sell pounds at $1.60 after 90 days
• On maturity bank deposit = £520,000
• Sell £520,000 in forward market at $1.60 to get $832,000
• This 4% return is 2% more than that of US deposit return
Contd..
• Covered interest arbitrage requires funds to be tied up, unlike that in
locational or triangular arbitrage
• This strategy would not have been advantageous if it earned 2% or
less
• The term arbitrage here suggests that you can guarantee return on
your funds that exceeds the return you could achieve domestically
Realignment due to Covered Interest
Arbitrage
• As many investors capitalize on covered interest arbitrage it would
put downward pressure on the forward rate, thus, discount on
forward would set off the advantage of the interest rate differentials
• Timing of Realignment:
• Realignment would happen after some transactions take place and interest
rates may adjust with a lag, so investors who initially entered into forward
rate may have initial arbitrage advantage
• It is also possible that spot rate could also experience upward pressure due to
increased demand, then forward rate may not have to decline exactly by the
interest rate differential between the home and foreign country
• However, since the forward market is generally less liquid so in most cases
almost entire adjustment would happen in forward rate
Covered Interest Arbitrage: Example Post
realignment
• Suppose in the previous example, as a result of covered interest
arbitrage 90-day Forward rate of pound declined to $1.5692. Find out
if covered interest arbitrage leads to higher return for US investor?
Covered Interest Arbitrage: Solution
• Solution
• Converting $800,000 to pounds = £500,000 (at spot rate of $1.60 per £)
• Deposit £500,000 in UK bank at 4% rate
• Simultaneously set up forward contract to sell pounds at $1.5692 after 90 days
• On maturity bank deposit = £520,000
• Sell £520,000 in forward market at $1.5692 to get $815,984
• Yield = ($815,984-$800,000)/$800,000 = .02 or 2%
• Thus, the example shows that the return of US investment and covered
interest arbitrage are same, implying there is no benefit to US investor
entering into covered interest arbitrage after the forward rate has declined
Covered Interest Arbitrage: With Bid-Ask Spread
• Q. Following are the spot and 1-year forward exchange rates

Bid Quote Ask Quote

Euro Spot $1.12 $1.13
Euro 1-Year Forward 1.12 1.13
Deposit Rate Loan Rate
Interest Rate on dollars 6.0% 9.0%
Interest Rate on Euros 6.5% 9.5%

• You have $100,000 to invest for 1 year. Would you benefit from
engaging in covered interest arbitrage?
Covered Interest Arbitrage: With Bid-Ask
Spread
• Sol.
1. Convert $1,00,000 to euros (ask quote): $100,000/$1.13=€88,496
2. Invest €88,496@6.5%: €88,496*1.065 = €94,248
3. Sell Euros for dollars at forward rate (bid quote):
€94,248*1.12=$105,558
4. Yield Earned: ($105,558- $1,00,000 )/ $1,00,000 = 5.0558%
• It is less than what you have earned by investing money in US for 1 year i.e.
6.0%.
• Hence, covered interest arbitrage is not feasible
Comparison of the Arbitrage Effects
Interest Rate Parity (IRP)
• Once market forces cause interest rates and exchange rates to adjust
such that covered interest arbitrage is no longer feasible, there is an
equilibrium state which is known as interest rate parity (IRP)
• In equilibrium the forward rate differs from the spot rate by sufficient
amount to offset the interest rate differential between the two
currencies
• While PPP deals with law of one price in markets of goods and
services, interest rate parity (IRP) concerns the law of one price in
financial market
Derivation of Interest Rate parity
• Consider a U.S. investor who attempts covered interest arbitrage with the
following return equation:
• Amount of home currency (US dollar) initially invested: Ah
• The spot rate (S) in dollars when foreign currency is purchased
• The interest rate on foreign deposit: if
• The forward rate (F) in dollars at which foreign currency would be converted
back to $
• Amount of home currency received at end of deposit period: An
An = (Ah/S)(1+if)F
Since F is simply S times 1 plus forward premium called as p, we can write
above equation as:
An = (Ah/S)(1+if)[S(1+p)]
= Ah(1+if)(1+p)
Contd..
• The rate of return from this investment (called R) is as follows:
A !A
R = nA h
h

Ah(1+if)(1+P)!Ah
= Ah
= (1+ if)(1+p)-1
If IRP exists, then rate of return achieved from covered interest arbitrage (R)should
be equal to rate available in the home country i.e.
R = ih
• By re-arranging we can determine forward premium under IRP:
(1+ if)(1+p)-1 = ih
(1+ if)(1+p) = 1+ ih
1+i
1+p = 1+ih
1+ihf
p = 1+i -1
f
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:
1 + ih
p= -1
1+ if
where
p = forward premium
ih = home interest rate
i f = foreign interest rate
Determining Forward Premium: Example
• Assume Mexican peso exhibits 6-month interest rate at 6%, while US dollar
exhibits a 6-month interest rate of 5%. From U.S. perspective, according to
IRP forward premium would be:
1+0.05
• p = 1+0.06 -1 =-0.0094 0r -0.94% (not annualized)
• Thus, U.S. investor should receive 0.94% less peso while selling them for 6
months from now, such discount would offset the interest rate advantage
of the peso.
• If peso’s spot rate is $.10, its forward rate would be:
• F = S(1+p) = $0.10 (1-.0094)=$.09906
• Assume in the previous example investor has $1,00,000 to invest. Can he
create interest rate arbitrage?
Implications of IRP
• If forward premium is equal to the interest rate differential covered
interest arbitrage would not be possible.
• Investor has $1,00,000 to invest.
• Step1: On day1 US investor converts $ into Peso at $0.10 per peso:
• $1,00,000/0.10 =MXP10,000,000
• Step 2: On day1 US investor sells 6 month forward. Number of Peso to be
sold forward : MXP10,000,000 (1.06) =MXP10,600,000
• Step3: After 6 months investor converts pesos into $:
• MXP10,600,000 *($0.09906) = $1,050,036
• Which is about 5% return, the same he would have got had he invested in $
for 6 months
• This confirms that covered interest arbitrage is not worthwhile if IRP exist.
Determining the forward premium
• The relationship between the forward premium (or discount) and the
interest rate differential according to IRP is simplified in an
approximated form:

F -S
p= @ ih - i f
S
where
p = forward premium (or discount)
F = forward rate in dollars
S = spot rate in dollars
ih = home interest rate
i f = foreign interest rate
 Exhibit 7.9 Illustration of Interest Rate Parity

40
40
Interpretation of Interest Rate Party
• IRP does not imply that investors from different countries will earn same
returns.
• It is focussed on the comparison of foreign investment and a domestic
investment in risk-free interest bearing securities by a particular investor
• Example: Assume US has 10% interest rate while UK has 14% interest rate
• US investor can achieve 10% domestically or attempt to use covered interest
arbitrage
• IF IRP exist then covered interest arbitrage should also lead to 10% return for US
investor and UK investor would receive 14% return
• Thus, in nominal terms they do not achieve same returns even if IRP exist but they
can not use covered interest arbitrage to earn higher returns than their respective
home countries returns
Considerations when Assessing Interest Rate
parity
• In absence of IRP covered interest arbitrage is possible, however due
to various characteristics of foreign investments it may not be
possible:
• Transaction Costs
• Political Risk
• Differentials Tax laws