International Financial Management

13th Edition
by Jeff Madura

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 7 International Arbitrage And Interest Rate Parity
Chapter Objectives

• Explain the conditions that will result in locational arbitrage

and the realignments that will follow.
• Explain the conditions that will result in triangular arbitrage
and the realignments that will follow.
• Explain the conditions that will result in covered interest
arbitrage and the realignments that will follow.
• Explain the concept of interest rate parity.
• Explain the variation in forward rate premiums across
maturities and over time.

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 International Arbitrage (1 of 7)

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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 International Arbitrage (2 of 7)

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. (See Exhibit 7.1)
• Gains from locational arbitrage are based on the amount
of money used and the size of the discrepancy. (See Exhibit
7.2)
• Realignment due to locational arbitrage drives prices to
adjust in different locations so as to eliminate discrepancies.

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 Exhibit 7.1 Currency Quotes for Locational Arbitrage
Example

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 Exhibit 7.2 Locational Arbitrage

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 International Arbitrage (3 of 7)

Triangular Arbitrage
• Defined as currency transactions in the spot market to
capitalize on discrepancies in the cross exchange rates
between two currencies. (See Exhibits 7.3, 7.4, & 7.5)
• Gains from triangular arbitrage: Currency transactions are
conducted in the spot market to capitalize on the
discrepancy in the cross exchange rate between two
countries.
• 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. (See Exhibit 7.6)

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 Exhibit 7.3 Example of Triangular Arbitrage

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 Exhibit 7.4 Currency Quotes for a Triangular
Arbitrage Example with Transaction Costs

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 Exhibit 7.5 Example of Triangular Arbitrage
Accounting for Bid/Ask Spreads

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 Exhibit 7.6 Impact of Triangular Arbitrage

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 International Arbitrage (4 of 7)

Covered Interest Arbitrage

• Steps involved in 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: (Exhibit 7.7)
• Interest arbitrage: the process of capitalizing on the
difference between interest rates between two countries.
• Covered: hedging the position against interest rate risk.
• Realignment due to covered interest arbitrage causes
market realignment.
• Timing of realignment may require several transactions
before realignment is completed.

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 Exhibit 7.7 Example of Covered Interest Arbitrage

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 International Arbitrage (5 of 7)

Covered Interest Arbitrage (cont.)

• Realignment is focused on the forward rate
• the forward rate is likely to experience most if not all of
the adjustment needed to achieve realignment.
• 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.
• Covered interest arbitrage by Non-U.S. investors
• The concept of covered interest arbitrage applies to any
two countries for which there is a spot rate and a forward
rate between their currencies as well as risk-free interest
rates quoted for both currencies.
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 International Arbitrage (6 of 7)

Comparison of Arbitrage Effects (Exhibit 7.8)

• The threat of locational arbitrage ensures that quoted
exchange rates are similar across banks in different
locations.
• The threat of triangular arbitrage ensures that cross
exchange rates are properly set.
• The threat of covered interest arbitrage ensures that forward
exchange rates are properly set. Any discrepancy will trigger
arbitrage, which should eliminate the discrepancy.
• Thus, arbitrage tends to allow for a more orderly foreign
exchange market.

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 International Arbitrage (7 of 7)

Comparison of Arbitrage Effects (cont.)

• How arbitrage reduces transaction costs
• Locational arbitrage limits the differences in a spot
exchange rate quotation across locations, while covered
interest arbitrage ensures that the forward rate is
properly priced. Thus, an MNC’s managers should be
able to avoid excessive transaction costs.

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 Exhibit 7.8 Comparing Arbitrage Strategies

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17 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Interest Rate Parity (1 of 6)

In equilibrium, the forward rate differs from the spot

rate by a sufficient amount to offset the interest rate
differential between two currencies.
Derivation of Interest Rate Parity

1  ih
p 1
1 if
where
p  forward premium
ih  home interest rate
i f  foreign interest rate

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 Interest Rate Parity (2 of 6)

Determining the Forward Premium

• Effect of the interest rate differential: 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

• 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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 Interest Rate Parity (3 of 6)

Graphic Analysis of Interest Rate Parity (Exhibit 7.9)

• Points representing a discount: points A and B
• Points representing a premium: points C and D
• Points representing IRP: points A, B, C, D
• 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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20 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Exhibit 7.9 Comparing Arbitrage Strategies

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21 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Interest Rate Parity (4 of 6)

How to Test Whether Interest Rate Parity Holds

(Exhibit 7.9)
• The location of the points provides an indication of
whether covered interest arbitrage is worthwhile.
• For points to the right of the IRP line, investors in the
home country should consider using covered interest
arbitrage, since a return higher than the home interest
rate (ih) is achievable.
• Of course, as investors and firms take advantage of such
opportunities, the point will tend to move toward the IRP
line.
• Covered interest arbitrage should continue until the
interest rate parity relationship holds.
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 Interest Rate Parity (5 of 6)

Interpretation of Interest Rate Parity

• Interest rate parity does not imply that investors from
different countries will earn the same returns.
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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 Interest Rate Parity (6 of 6)

Considerations When Assessing Interest Rate Parity

• 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. (See Exhibit
7.10)
• Political risk
• A crisis in the foreign country could cause its government to
restrict any exchange of the local currency for other
currencies.
• 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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 Exhibit 7.10 Potential for Covered Interest Arbitrage
When Considering Transaction Costs

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 Variation in Forward Premiums

Forward Premiums across Maturities

• The annualized interest rate differential between two countries can
vary among debt maturities, and so will the annualized forward
premiums.(See Exhibit 7.11)
Changes in Forward Premiums over Time
• Exhibit 7.12 illustrates the relationship between interest rate
differentials and the forward premium over time, when interest rate
parity holds. The forward premium must adjust to existing interest
rate conditions if interest rate parity holds.
• Explaining changes in the forward rate
• The forward rate is indirectly affected by all the factors that can
affect the spot rate (S) over time, including inflation differentials,
interest rate differentials, etc. The change in the forward rate
can also be due to a change in the premium.
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 Exhibit 7.11 Quoted Interest Rates for Various Times
to Maturity

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 Exhibit 7.12 Relationship over Time between the
Interest Rate Differential and the Forward Premium

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 SUMMARY (1 of 4)

• Locational arbitrage may occur if foreign exchange

quotations differ among banks. The act of locational
arbitrage should force the foreign exchange quotations of
banks to become realigned, after which locational
arbitrage will no longer be possible.
• Triangular arbitrage is related to cross exchange rates. A
cross exchange rate between two currencies is
determined by the values of these two currencies with
respect to a third currency. If the actual cross exchange
rate of these two currencies differs from the rate that
should exist, triangular arbitrage is possible. The act of
triangular arbitrage should force cross exchange rates to
become realigned, at which time triangular arbitrage will
no longer be possible.
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 SUMMARY (2 of 4)

• Covered interest arbitrage is based on the relationship

between the forward rate premium and the interest rate
differential. The size of the premium or discount exhibited by
the forward rate of a currency should be about the same as
the differential between the interest rates of the two countries
of concern. In general terms, the forward rate of the foreign
currency will contain a discount (premium) if its interest rate
is higher (lower) than the U.S. interest rate.
• If the forward premium deviates substantially from the interest
rate differential, then covered interest arbitrage is possible. In
this type of arbitrage, a short-term investment in some foreign
currency is covered by a forward sale of that foreign currency
in the future. In this manner, the investor is not exposed to
fluctuation in the foreign currency’s value.
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 SUMMARY (3 of 4)

• According to the theory of interest rate parity (IRP), the

size of the forward premium (or discount) should be
equal to the interest rate differential between the two
countries of concern. If IRP holds then covered interest
arbitrage is not feasible, because any interest rate
advantage in the foreign country will be offset by the
discount on the forward rate. Thus, covered interest
arbitrage would not generate higher returns than would
be generated by a domestic investment.

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 SUMMARY (4 of 4)

• Because the forward premium of a currency (from a

U.S. perspective) is influenced by the interest rate of
that currency and the U.S. interest rate and because
those interest rates change over time, it follows that the
forward premium changes over time. Thus, a forward
premium that is large and positive in one period, when
the interest rate of that currency is relatively low, could
become negative (reflecting a discount) if that interest
rate rises above the U.S. level.

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