o types of Arbitrage
o Locational arbitrage
o Triangular arbitrage
o Covered interest
o Interest rate parity
o Simultaneous purchase and sale of
commodities or financial instruments in
various market to profit from unequal
prices without risk.
o arbitrage take benefit from discrepancy
in prices they purchase from a place
where prices are low and sold where the
prices are high.
o arbitrage earn riskless profit
As applied to foreign exchange and
international money markets,
arbitrage takes three common forms:
o locational arbitrage
o triangular arbitrage
o covered interest 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.
Bank C Bid
Bank D Bid
Buy NZ$ from Bank C @ $.640, and sell it to Bank D
@ $.645. Profit = $.005/NZ$.
o Buy NZ$ from Bank C @ $.640, and sell
it to Bank D @ $.645. Profit =
o A person can obtain New Zealand dollars
for “Bank A” at the ask price of $.640
and then sell New Zealand dollars to
“Bank B” at the bid price of $.645. This
represent a “one round trip” transaction
in Locational arbitrage.
When the actual cross exchange rate between
two currencies differ from spot rate. the process
of taking one currency and converting it into
another currency only to convert it back to
British pound (£)
Malaysian ringgit (MYR)
Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @
$.200. Profit = $.01/£. (8.1 .2=1.62)
o Assume that, a bank has quoted the British pound (£) at $
1.60, the Malaysian Ringgit (MYR) at $ .20, and the cross
exchange rate at £ 1 = MYR 8.1.
o Your first tats would be determine the cross exchange rate
that is Pound should be worth MYR8.0
o When quoting an exchange rate of £ 1 = .81, the bank is
exchanging too many Ringgit for a pound and is asking for
too many Ringgit in exchange for a pound. Based on this
information, you can engage in triangular arbitrage by
purchasing pounds with dollar, converting the Pounds to
Ringgit and then exchanging the Ringgit for dollars.
o Covered interest arbitrage is the process of capitalizing
on the interest rate differential between two countries,
while covering for exchange rate risk.
o The logic of the term Covered interest arbitrage become
clear when it is broken into two parts; “interest
arbitrage” and “covered”.
o Interest arbitrage refers to the process of capitalizing on
the difference between interest rates between two
countries. On the other hand, Covered refers to hedging
your position against exchange rate risk.
o Covered interest arbitrage involving investment
dominated in different currencies using forward covered
to reduce or eliminate currency risk
o Once market forces cause interest rates and exchange rates
to adjust such that covered interest arbitrage is no longer
feasible, there is an equilibrium state referred to as Interest
o 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.
o Then, covered interest arbitrage is no longer feasible, and
the equilibrium state achieved is referred to as interest rate
o When IRP exists, it does not mean
both local and foreign investors will earn
the same returns.
o What it means is that investors cannot
use covered interest arbitrage to achieve
higher returns than those achievable in
their respective home countries.
o To test whether IRP exists, collect
actual interest rate differentials and
forward premiums for various
currencies, and plot them on a
o IRP holds when covered interest
arbitrage is not possible or
o Various empirical studies indicate that IRP
o While there are deviations from IRP, they
are often not large enough to make covered
interest arbitrage worthwhile.
o This is due to the characteristics of foreign
investments, such as transaction costs,
political risk, and differential tax laws.
o End-value of a $1 investment in the home country
= 1 + iH
o Equating the two and rearranging terms:
(1 + home interest rate)
(1 + foreign interest rate)
o The IRP relationship can be rewritten as
S(1+p) – S
o The approximated form, p iH – iF,
provides a reasonable estimate when
the interest rate differential is small.
o Locational arbitrage ensures that quoted exchange
rates are similar across banks in different locations.
o Triangular arbitrage ensures that cross exchange
rates are set properly.
o Covered interest arbitrage ensures that forward
exchange rates are set properly.
o Any discrepancy will trigger arbitrage, which will
then eliminate the discrepancy. Arbitrage thus
makes the foreign exchange market more orderly.