77 CChhaapptteerr IInntteerrnnaattiioonnaall AArrbbiittrraaggee AAnndd IInntteerreesstt RRaattee PPaarriittyy J. Gaspar: Adapted from Jeff Madura, International Financial Management 7.1 Major International Finance Theories The objective of International Finance theories is to understand how and why, in a system of free markets and flexible exchange rate, currencies strive to move toward equilibrium. These theories define the relationship between exchange rates (current spot, future spot, and forward), inflation, and nominal interest rate movements. 7.2 Theory One: Interest Rate Parity (IRP) According to IRP, at equilibrium, the forward rate of a foreign currency will differ (in %) from the current spot rate by an amount that will equal the interest rate differential (in%) between the home and foreign country. However, before one proceeds to discuss IRP, the concept of currency arbitrage needs to be explored first. 7.3 Chapter Objectives To explain the conditions that will result in various  forms of currency arbitrage, along with the currency realignments that will occur in response; and To explain the concept of interest rate parity, and  how it prevents foreign exchange arbitrage opportunities. 7.4 International Arbitrage • Arbitrage can be defined as capitalizing on a discrepancy in quoted prices to make a risk-free profit. • The effect of arbitrage on demand and supply is to cause prices to realign, such that risk-free profit is no longer feasible. • International Arbitragers play a critical role in facilitating exchange rate equilibrium. They try to earn a risk-free profit whenever there is exchange rate disequilibrium. 7.5 International Arbitrage • As applied to foreign exchange and international money markets, international arbitrage (i.e., taking risk-free positions by buying and selling currencies simultaneously) takes three major forms: • locational arbitrage • triangular arbitrage • covered interest arbitrage 7.6 Locational Arbitrage • Locational arbitragers try to offset spot bid-ask exchange rate disequilibrium • 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 NZ$ $.635 $.640 NZ$ $.645 $.650 Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$. 7.7 Triangular Arbitrage • Triangular arbitragers try to offset cross-rate disequilibrium • Triangular arbitrage is possible when a cross exchange rate (exchange rate between two foreign currencies) quoted by a bank differs from the rate calculated from dollar-based spot rate quotes. Example Bid Ask Bank A: British pound (£) $1.60 $1.61 Bank B: Malaysian ringgit (MYR) $.200 $.201 Bank C: British pound (£) MYR8.10 MYR8.20 Calculated cross rate (A/B) £ MYR8.00 MYR8.01 7.8 Conducting Triangular Arbitrage • Cross rates (£/MYR) are in disequilibrium and there is room for risk-free profit if the American arbitrager had access to £ • Challenges: US arbitragers do not (1) have £, and (2) calculated cross rates are not quoted by banks • Example: Let’s assume that the US arbitrager has $10,000 to invest in deal and let’s see how much profit could be made. 7.9 Profit from Triangular Arbitrage • Sell $10,000 and buy £ from Bank A = $10,000 ÷ 1.61 = £6,211 • Sell £6,211 to buy MYR at Bank C = £6,211 x 8.10 = MYR50,309 • Sell MYR50,309 to buy $ at Bank B = MYR50,309 x 0.20 = $10,062 • Triangular arbitrage profit = $10,062 - $10,000 = $62 or ($62/$10,000)x100= 0.62% 7.10