Chapter

7
International Arbitrage And
Interest Rate Parity

South-Western/Thomson Learning © 2003

 Chapter Objectives

• To explain the conditions that will result in

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

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 International Arbitrage

• Arbitrage can be loosely defined as

capitalizing on a discrepancy in quoted
prices. Often, the funds invested are not
tied up and no risk is involved.
• In response to the imbalance in demand
and supply resulting from arbitrage activity,
prices will realign very quickly, such that
no further risk-free profits can be made.

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 International Arbitrage
• Locational arbitrage is possible when a bank’s buying price (bid price) is
higher than another bank’s selling price (ask price) for the same
currency.
• Example:
Bank C Bid Ask Bank D Bid Ask
US $ Tk.69 Tk.70 US $ Tk.71 Tk.72
Buy dollar from Bank C @ Tk.70, and sell it to Bank D @ Tk.71. Profit
= 1.4%.
Effects: Demand for Bank C dollar increases and supply of Bank D
dollar increases. Dollar rate of Bank C would increase, and dollar rate
of Bank D would decrease leading to off-set the arbitrage opportunity.

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 International Arbitrage

$
Value of Value of
£ in $ $ in Tk.

£ Tk.
Value of
£ in Taka

• When the exchange rates of the currencies are not in

equilibrium, triangular arbitrage will force them back
into equilibrium.

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 International Arbitrage
• Triangular arbitrage is possible when a cross exchange rate
quote differs from the rate calculated from spot rates.
• Example:
Bid Rate Ask Rate
British pound (£) Tk.130 Tk.135
US dollar Tk.69 Tk.71
Pound $2 $2.2

Step 1: Invest Tk.1,000 to buy pound £7.41 @£1=Tk.135.

Step 2: Sell pound against dollar @£1=$2 and get $14.8.
Step 3: Sell dollar @$1=Tk.69 and get Tk.1022.

This gives you 2.2% profit.

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 International Arbitrage

• Covered interest arbitrage is the process

of capitalizing on the interest rate
differential between two countries, while
covering for exchange rate risk.
• Covered interest arbitrage tends to force a
relationship between forward rate
premiums and interest rate differentials.

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 International Arbitrage
• Example:
Dollar spot rate = 90-day forward rate = Tk.70
U.S. 90-day interest rate = 3%
Dhaka 90-day interest rate = 2%
Step 1: Day 1: Borrow Tk.1,000 from Sonali Bank at 2% interest, and
buy $14.286
Step 2: Day 1: Put the amount in US deposit @3%
Step 3: Day 1: Make a forward sell contract of $14.7 against Tk.1,030.
Step 4: Day 90: Get the dollar back and make the settlement of forward
contract.
Step 4: Day 90: Return back Sonali Bank Tk.1, 020, make a profit of 1%.

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Effects of 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.

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 Interest Rate Parity (IRP)

• Market forces cause the forward rate to

differ from the spot rate by an amount that
is sufficient to offset the interest rate
differential between the two currencies.
• Then, covered interest arbitrage is no
longer feasible, and the equilibrium state
achieved is referred to as interest rate
parity (IRP).

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 Derivation of IRP
• When IRP exists, the rate of return achieved from covered interest
arbitrage should equal the rate of return available in the home
country.
• End-value of a Tk.1 investment in covered interest arbitrage:
= (1/S)  (1+iF)  F
= (1/S)  (1+iF)  [S  (1+p)]
= (1+iF)  (1+p)
where p is the forward premium.
• End-value of a Tk.1 investment in the home country = 1 + iH
• Equating the two and rearranging terms, forward premium is:
p = (1+iH) – 1
(1+iF)
i.e.
forward = (1 + home interest rate) – 1
premium (1 + foreign interest rate)

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Determining the Forward Premium

Example:
• Suppose 6-month i$ = 3%, iTk = 2%.
• From the Bangladesh investor’s perspective,
forward premium = 1.02/1.03 – 1  - .00971
• If S = Tk.80, then
6-month forward rate = S  (1 + p)
 80  (1 _ .00971)
 Tk.79.223

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 Proof
• Home interest rate is 2%
• Foreign interest rate is 3%
• At Dhaka, Investment of Tk.80 becomes (80*1.02)
or Tk.81.60 at the end of the period (including
interest)
• In USA invest $1 by Tk.80 today and get $1.03 at
the end of the period. The forward rate turns up
$1=Tk.79.223, at that rate, the taka amount you get
by exchanging $1.03 is ($1.03*79.223) or Tk.81.60.
This is exactly the same you get from home
investment.

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 Arbitrage effect in forward market at
Dhaka

• $1=Tk.

S1
S2
.

80
79.22

Quantity of foreign exchange

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 International Arbitrage
• Example:
Dollar spot rate = 90-day forward rate = Tk.70
U.S. 90-day interest rate = 3%
Dhaka 90-day interest rate = 4%
Step 1: day 1: A US investor would borrow $100 from a local bank at 3%
interest for 90 days.
Step 2: day 1: Convert dollar into taka in the spot market and get Tk.7,000.
Step 3: day 1: Deposit the amount of Tk.7,000 at a bank at Dhaka for a
period of 90 days at 4% interest.
Step 4: day 1: Make a forward purchase contract of dollar ($104) against
Tk.7,280 (Tk.7,000*1.04).
Step 4: Day 90: Get the taka back from the bank at Dhaka to an amount of
Tk,7,280.
Step 5: Day 90: Make the settlement of forward contract , and realize $104.
Step 6: Day 90: Return back $103 to the local bank and make a profit of $1.

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Determining the Forward Premium

• Note that the IRP relationship can be

rewritten as follows:
F – S = S(1+p) – S = p = (1+iH) – 1 = (iH–iF)
S S (1+iF) (1+iF)
• The approximated form, p  iH–iF, provides
a reasonable estimate when the interest
rate differential is small.

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 Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
4

IRP line
2

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)

-2

-4
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 Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate – foreign interest rate
4
Zone of potential
covered interest IRP line
arbitrage by
foreign investors 2

Forward -3 -1 1 3 Forward
Discount (%) Premium (%)
Zone of potential
- 2 covered interest
arbitrage by
local investors
-4
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Considerations When Assessing IRP
Political Risk
¤ A crisis in the foreign country could cause its
government to restrict any exchange of the
local currency for other currencies.
¤ Investors may also perceive a higher default
risk on foreign investments.
Differential Tax Laws
¤ If tax laws vary, after-tax returns should be
considered instead of before-tax returns.

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