Chapter 7

International Arbitrage
and Interest Rate Parity

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 Objectives :
1. Explain the conditions that will result in
various forms of international arbitrage
opportunities.
2. Explain the process international arbitrage
realignment and the concept of
international rate parity.

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 International Arbitrage

Definition :
• Can be loosely define as capitalizing on a
discrepancy in quoted prices

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 Example:

2 shops buys and sells an identical Spanish coins

Shop A Shop B
Buying Price 120 Buying Price 140
Selling Price 130 Selling Price 150

• Mr. Smith will buy from shop A at (RM130) and

sell it to shop B at (RM140).
• This transaction result in RM 10 return.
• Engage in Arbitraging process.

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Example of locational arbitrage:
Value of 1
Bid(buy) Ask( sell)
unit $NZ
Bank C $0.635 $0.640
Bank D $0.645 $0.650
Assume you have $10,000 for investment.

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 Step 1 : Purchase $NZ from bank (C) with ask rate
$NZ 0.640
1 $NZ = $0.640
? NZ = $10,000
$10,000
1
$0.640
= $15,624 NZ

Step 2 : Sell NZ to bank (D) with bid rate $0.645.

$NZ = $0.645
$15,625 = ?
$15,625
 $0.645
1
= $10,078

Step 3 : Compute profit : $10,078 − $10,000

= $78 (profit)

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Realignment due to locational arbitrage

• Increase in demand for NZ currency at Bank C

pushes the ask price to a higher level. i.e
$0.640→$0.645
• Increase in supply for NZ currency at Bank D pushes
the bid price to a lower level. i.e $0.645→$0.635

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 Triangular Arbitrage
• Triangular arbitrage is possible when the
quoted exchange rate is different from the
intrinsic rate calculated from the spot rate.

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 Example of Triangular Arbitrage

Quoted Price
Value of 1 unit Canadian in US$ $0.90
Value of 1 unit NZ in US$ $0.30
value of 1 unit Canadian in NZ
NZ3.02
(quoted)

• Assume you have $10,000

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Step 1 :

Determine if the intrinsic rate is greater or less than

the given quoted rate of Canadian and NZ dollar.

Value of currency X (1 unit) in unit at currency Y

value of  in $
value of  in $

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Step 1 (cont.):

- cross rate value of 1 unit Canadian dollar in

unit of NZ
$0.90/$0.30 = 3.0
- 1 unit of Canadian dollar is equivalent
to 3 unit of NZ.

Since cross rate is different than the quoted

exchange rate, therefore there is possibility of
profit generation.

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Step 2 : Determine which currency being overvalued
by the financial Institution

- Quoted rate
1 $Canadian dollar = $NZ 3.02

- Intrinsic rate
1 $Canadian dollar = $NZ 3.00

•The Financial Institution has overvalued the Canadian

Dollar with respect to NZ dollar.

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Step 3 : Convert US$10,000 to Canadian dollar
( overvalued currency).
1C = $0.90
? = $10,000
10,000US$
1C
0.9 US$
=11,111C

Step 4 : Convert $Canadian to $NZ

1C = 3.02NZ
11,111C = ?NZ
11,111C
 3.02 NZ
1C
= 33,555NZ
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Step 5 : Convert NZ$35,555 to US$
1NZ = US$0.3
35,555 NZ
 $0.3
1NZ
= US$10,066

Step 6 : Determine profits

US$10,066 - US$10,000
= US$66

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What if convert the capital into NZ dollar first?
(the undervalued currency)

Step 2 : Step 3 :
Convert US$10,000 to NZ Convert NZ$33,333 to
Canadian dollar
US$10,000
 1NZ $1C = NZ$3.02
US$0.30
NZ$33,333
= NZ$33,333
$1C 
NZ$3.02
= $C11,037

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Step 4 : Step 5 :
Convert $11,037C to Compute profit
US$ US$9,933 – US$10,000
1C = US$0.90 = -US$66.32
$11,037C
 US$0.90
$1C
=US$9,933

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 Example 2
Quoted Price
Value of 1 unit Canadian in US$ $0.90
Value of 1 unit NZ in US$ $0.30
value of 1 unit Canadian in NZ
$NZ 2.80
(quoted)

• Assume you have $10,000

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Step 1 :

Determine if the intrinsic rate is greater or less than

the given quoted rate of Canadian and NZ dollar.

Value at currency X (1 unit) in unit at currency Y

value of  in $
value of  in $

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Step 1 (cont.):

- cross rate value of 1 unit Canadian dollar in

unit of NZ
$0.90/$0.30 = 3.0
- 1 unit of Canadian dollar is equivalent
to 3 unit of NZ.

Since cross rate is different than the quoted

exchange rate, therefore there is possibility of
profit generation.

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Step 2 : Determine which currency being overvalued
by the financial Institution

- Quoted rate
1 $Canadian dollar = $NZ 2.80

- Intrinsic rate
1 $Canadian dollar = $NZ 3.00

•The Financial Institution has overvalued the NZ dollar

with respect to Canadian dollar.

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Step 2 : Step 3 :
Convert US$10,000 to NZ Convert NZ$33,333
US$10,000 to Canadian dollar
 1NZ $1C = NZ$2.08
US$0.3
NZ$33,333
= NZ$33,333
$1C 
NZ$2.80
= $C11,905

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Step 4 : Convert $C11,905 to US$
$1C = $0.90
$11,905/$1C X $0.90
=$10,714

Step 5 : Determine Triangular Arbitrage

profit
$10,714 – $10,000
= $714

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 Covered interest arbitrage

Covered interest arbitrage is a process of capitalizing on the

interest rate differential between 2 countries while covering
for exchange rate risk.

i.e Assume the following information:

you have $100,000 to invest
the current spot rate at Dutch mark (Dm) in US
dollar is $1.60
the 90 day forward rate of Dm in US dollar is
$1.60
the 90 day interest rate in Germany is 4%
the 90 day interest rate in the US is 2%
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Step 1 : Convert $100,000 to DM
$100,000/$1.60 X 1DM
=$62,500DM
Step 2 : Calculate accumulated DM over 90 days at 4%
62,500 X (1.04)
=65,000 DM
Step 3 : Establish forward contract to sell the
accumulated DM after 90 days(65,000DM)
Step 4 : Reconvert the accumulated DM to US dollar
after 90 days using forward rate
1DM = $1.60
65,000DM = ?
65,000DM/1DM X $1.60
= $104,000
Step 5 : Determine investment profit
$104,000 - $100,000
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= $4000
Realignment due to covered interest arbitrage

Engage in forward contract to sell the accumulated

investment denominated in DM.
• ↑ the supply of DM in forward market
• ↓ pressure on the forward rate of the DM (i.e $1.60→$1.50)

From step 4
Reconvert the accumulated DM to US dollar after 90days
using forward rate ; 1DM = $1.50
1DM = $1.50
65,000 = ?$
65,000DM/1DM X $1.50
=$97,500

Step 5 : Determine profit/loss

97,500 – 100,000(initial investment) 25
= $ -2,500
 Interest Rate Parity

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 countries.
As a result, covered interest arbitrage is no longer
feasible and the equilibrium state achieved is referred to
as interest rate parity (IRP).
When IRP exist, the rate of return achieved from covered
interest arbitrage should equal the rate of return
available in the home country (i.e. US market VS
Germany market).

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 Interest Rate Parity

For Int. rate parity to exist, the forward rate would have
to be different from the spot rate by an amount that is
sufficient to offset the interest rate differential between
the two countries.
In order to determine how much the forward rate has to
change;
(1  hom e int.rate)
Ef  forward Premium  1
1  foreign interest rate
Ef = changes in value of foreign currency (forward rate)
If Ef (-), this implies foreign currency forward rate would decline

If Ef (+), this implies foreign currency forward rate would increase

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 Example 1

Interest in Mexico = 6%
Interest rate in the US = 5%
Ef = ? Forward rate

(1  hom e int.rate)
Ef  forward Premium  1
1  foreign interest rate

(1  0.05)
 1
(1  0.06)
 0.0094
 - 0.094%

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 Example 1 (cont.)

Expected changes in value of forward rate for Peso is

-0.094%.

•If the spot rate today is →1 Peso = $0.10

•Forward rate (adjusted) = S(1+P)
= $0.10 (1-0.0094)
1 Peso = $0.09906

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Assume the following information

•You have $100,000 to invest

•Current spot rate US$ to Mexican Peso
1Peso = $0.10
•90 day forward rate US$ to Peso
1 Peso = $0.09906
•90 day interest rate in Mexico = 6%
•90 day interest rate in US = 5%

Is covered interest arbitrage possible?

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Step 1 : Convert $100,000 to Peso @ 1Peso = $0.10
= $1,000,000

Step 2 : Accumulated Peso after 90 days @ 6%

1,000,000 X (1.06) = 1,060,000 Peso

Step 3 : Establish forward contract to sell 1,060,000 Peso

@ 1Peso = $0.09906

Step 4 : Reconvert to accumulated Peso to US$ after

90 days using forward rate.
1 Peso = $0.09906
1,060,000 Peso / 1 Peso X $0.09906 = $105,003

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Step 5 : Compare invest return if invest in US & if
invest in Mexico for 90 days

-invest in Mexico : $105,003

- invest in US : $100,000 X (1.05) = $105,000

•Thus the forward discount (1 Peso = $0.099) offset

the interest rate differential advantage for American
citizen.

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We can determine the forward rate using simpler formula:

P = éH - éF
éH = interest rate home
éF = interest rate foreign
P = % change in forward rate

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 Example

Mexico interest rate = 6%

US interest rate = 5% (home)
P = éH – é F
P = 5% - 6%
= -1%

Forward rate adjustment if current spot rate is

1 Peso = $0.10 (P=1%)
Forward rate = S (1+P)
=$0.10 (1- 1%)
=$0.10 (1- 0.01)
Forward rate discount = $0.099

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 Does IRP hold?

Various empirical studies indicate that IRP generally

hold.

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 Explaining Changes in Forward Premiums
Interest Rates i
A

iU.S
Because of IRP, a
forward rate will
normally move in
tandem with the
spot rate.
t0 t1 t2 This correlation
Interest Rates depends on
interest rate
movements,
SA i.e. P ≈ iH - iF
FA

t0 t1 t2 36
 Annualized interest rate
8%
8%

6%
6%
Forward Premium Changes
4%
4%
i€ Euro’s interest rate
2%
2%
i$
U.S. interest rate
0%
0%
Q3 Q1 Q3 Q1 Q3 Q1 Q3
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1
2%2000 i $ > i
2001
€ 2002 2003

i $ = i€
i$ – i€

0%
i $ < i€
-2%
Q3 Q1 Q3 Q1 Q3 Q1 Q3
Forward premium of €

2%2000
premium
2001 2002 2003

0%
discount
-2%
Q3 Q1 Q3 Q1 Q3 Q1 Q3 37
2000 2001 2002 2003
 Does IRP hold?

While there are deviations from IRP, they are often not
large enough to make covered interest arbitrage
worthwhile.
This is due to the characteristics of foreign
investments, including transaction costs, political
risk and differential tax law.

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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.
Investor may also perceive a higher default risk
on foreign investment.
 Differential tax law; investors may be subjected
to withholding tax

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