INTERNATIONAL FINANCE

1 Dr. Nathan (Thanh Nguyen)

 INTERNATIONAL
ARBITRAGE AND INTEREST
RATE PARITY

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 LEARNING OUTCOMES

This chapter will:

A. Explain the conditions that will result in
various forms of international arbitrage and the
realignments that will occur in response
B. Explain the concept of interest rate parity

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 INTERNATIONAL ARBITRAGE

Defined as capitalizing on a discrepancy in

quoted prices by making a riskless profit

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CLASSIFICATION OF ARBITRAGE

Locational Arbitrage

Triangular Arbitrage

Covered interest arbitrage

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 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

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 LOCATIONAL ARBITRAGE

Gains from locational arbitrage are based

on the amount of money used and the size
of the discrepancy.

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 LOCATIONAL ARBITRAGE

Example:

North Bank Bid Ask South BankBid Ask

NZ$ $.635 $.640 NZ$ $.645 $.650

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LOCATIONAL ARBITRAGE

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 LOCATIONAL ARBITRAGE

Akron Bank Zyn Bank

Bid Ask Bid Ask

£ quote $1,60 $1,61 £ quote $1,61 $1,62

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 LOCATIONAL ARBITRAGE

$NZ demand $NZ North bank

of North bank become increase
increase the $NZ
scarce
ask price

$NZ supply of South bank

South bank decrease the
increase $NZ bid price

Gains of locational 11
arbitrage decrease
 TRIANGULAR ARBITRAGE

Defined as currency transactions in the spot

market to capitalize on discrepancies in the
cross exchange rates between two
currencies.

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 TRIANGULAR ARBITRAGE

Example: Bid Ask

British pound (£) $1.60 $1.61

Malaysian ringgit (MYR)$.200 $.202

£ MYR8.1 MYR8.2
Assume investor have 10.000 USD to invest

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TRIANGULAR ARBITRAGE

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 TRIANGULAR ARBITRAGE
Activity Impact
Participants use dollars to Bank increases its ask price
purchase pounds. of pounds with respect to
the dollar
Participants use pounds to Bank reduces its bid price of
purchase Malaysian ringgit. the British pound with
respect to the ringgit; that
is, it reduces the number of
ringgit to be exchanged per
pound received.

Participants use Malaysian Bank reduces its bid price of

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ringgit to purchase U.S. ringgit with respect to the
dollars. dollar
 TRIANGULAR ARBITRAGE

Bid Ask

British pound (£) $1,95 $2,00

US dollar VND 17.500 VND 18.000

£ VND 36.900 VND 37.200

Assume investor is initial with10.000 USD

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 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.

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 COVERED INTEREST ARBITRAGE

The amount of money: 1,000,000,000 VND

SGD spot rate: 0.0735/1000 VND
SGD 90 days forward rate 0.0735/1,000 VND
Vietnam 90 days rate: 2%
Singapore 90 days rate: 4%
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 COVERED INTEREST ARBITRAGE

Convert 1,000,000,000 VND

1 to 73.500 SGD and deposit Sell 76.440 SGD
in Singapore bank
+ 90 days forward

By the time the deposit

2 matures, you will have
76.440 SGD (including interest).

Convert 76.440 SGD

3 into 1.040.000 VND based
on the forward contract rate 19

of SGD 0.0735/1000 VND

 COVERED INTEREST ARBITRAGE

There is upward
1 Convert VND into
pressure on
SGD on spot market
VND spot rate

There is downward
2 Engage in a forward
pressure on the
contract to sell SGD
90-day VND forward rate

There is upward
3 VND invest into pressure on Viet Nam
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Singapore and downward on
Singapore interest rate
 COVERED INTEREST ARBITRAGE
Bid Ask

Euro Spot $1,12 $1,13

1 year Euro $1,12 $1,13

forward rate
USD interest 6,0%
rate
Euro interest 6,5%
rate

You have 100,000 USD to invest within 1 year. 22

Do you gain profit with CIA?

 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.

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 INTEREST RATE PARITY- IRP

F= S(1 + p)

Premium or Discount (p):

F > S  p > 0 : Premium

F
p = −1
S
F < S  p < 0 : Discount
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 INTEREST RATE PARITY- IRP

An investor act of CIA, so the amount of the home

currency received at the end of the deposit period
due to such a strategy

An = (Ah/S)(1+ if)F

Ah : The amount of the home currency that is initially

invested
St : The spot rate of foreign currency
if : The interest rate on the foreign deposit
F : The forward rate
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An: The amount of the home currency received at the end of
the deposit period due to such a strategy
 INTEREST RATE PARITY- IRP

Since F = S(1+ p), we can rewrite this equation as:


An = (Ah/S)(1+ if)[S(1+ p)] = Ah(1+ if)(1+ p)

The rate of return from this investment (called R) is

as follows

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 INTEREST RATE PARITY- IRP

rf = (1+ if)(1+ p) – 1

If IRP exists, then the rate of return achieved

from covered interest arbitrage (rf) should be equal
to the rate available in the home country (ih)

rf = i h
(1+ if) (1+ p) – 1 = ih 27
 INTEREST RATE PARITY- IRP

By rearranging terms, we can determine what the

forward premium of the foreign currency should be
under conditions of IRP

1 + ih
p= -1
1+ i f
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 INTEREST RATE PARITY- IRP

Example 1
VND 6 months interest rate is 4%, USD 6 months
interest rate is 2%
Spot rate: 19,000VND/USD. An investor initial 1
billions VND

1 + 0,04
p= - 1 = 0,01960  1,97%
1 + 0,02
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F = S (1 + p ) = 19000(1 + 0.0197) = 19.3743
 INTEREST RATE PARITY- IRP

Relationship between Forward Premium and Interest Rate

differential
F- S
p= = ih - if
S

p: forward premium (or discount)

F: forward rate of home currency
S: spot rate of home currency
ih: home interest rate
if: foreign interest rate 30
GRAPHIC ANALYSIS OF INTEREST
RATE PARITY

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 GRAPHIC ANALYSIS OF 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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 GRAPHIC ANALYSIS OF 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 33

on
a foreign investment than on a domestic one.
CONSIDERATIONS WHEN ASSESSING
INTEREST RATE PARITY

 Transaction costs
 Political risk
 Differential tax laws

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