Arbitrage involves purchasing currency where it is cheaper and immediately reselling it where it is more expensive to make a profit. There are different types of arbitrage depending on the number of currencies and locations involved. Covered interest arbitrage moves funds between countries to exploit interest rate differences while hedging exchange rate risk using forward contracts. The international Fisher equation establishes a relationship between exchange rates and interest rates such that any arbitrage profits will be offset over time as markets adjust rates.

2. Arbitrage
• Purchase of a currency by speculation in the
monetary centre where it is cheaper for
immediate resale in the monetary centre where it
is more expensive so as to make a profit.
• Interest arbitrage refers to the international flow
of short-term liquid capital to earn higher returns
abroad.
• Interest arbitrage can be covered or uncovered.

3. Types of arbitrage
• When only 2 currencies and 2 monetary
centres are involved in the arbitrage
analysis, we call it as Two-point Arbitrage.
• When 3 currencies and 3 monetary centres
are involved, we have a triangular or
Three-point Arbitrage.
• Triangular Arbitrage operates so as to
ensure consistent Indirect or cross
exchange rates between the three
currencies in the three monetary centres.

4. Triangular Arbitrage

5. Covered Interest Arbitrage
• CIA is the movement of short term funds
between countries to take advantage of interest
differentials with the exchange risk covered by
the forward contracts.
• In other words, Covered interest arbitrage is
the investment strategy where an investor
buys a financial instrument denominated in
a foreign currency, and hedges his foreign
exchange risk by selling a forward
contract in the amount of the proceeds of the
investment back into his base currency.

6. Contd...
• Investors must also consider any losses or
gains, which might occur due to fluctuations in
the value of the foreign currency prior to the
maturity of their investment.
• Generally, the investors cover against such
partial losses by contracting for the future sale
or purchase of a foreign currency in the
forward market.

7. Why there is fluctuation?
• The forward rate and spot rate fluctuations occur
due to fluctuations in demand and supply of a
particular currency against the foreign currency.
• The changes in interest rate occur due to changes in
borrowing and investments preferences of the
investors in different countries.
• These fluctuations result in the arbitrage
opportunity being done for a very limited period
after which interest rates and the exchange rates
adjust to nullify the effect.

8. Contd..
• The strategy of Covered Interest Arbitrage
exist as an exploitation of the
International Fischer Equation and
Interest Rate parity between any two
countries while covering the risk using the
instrument of forward or future contract.

9. Uncovered Interest Arbitrage
• Uncovered interest arbitrage is a form of arbitrage
where funds are transferred abroad to take advantage
of higher interest in foreign monetary centers.
• It involves the conversion of domestic currency to the
foreign currency to make investment; and
subsequently re-conversion of the fund from the
foreign currency to the domestic currency at the time
of maturity.
• A foreign exchange risk is involved due to the possible
depreciation of the foreign currency during the period
of the investment.

10. Contd...

11. International Fisher Equation
=
• Shows the relationship between the foreign exchange market and the money
markets.
• Any gain or loss incurred by the investor in simultaneous transaction in
spot and forward market is offset by interest rate differential in two
countries.

12. Contd..
Mathematically, the International Fischer Equation is
established as:
Where i$ = interest rate in foreign country
F= forward rate
S= Spot rate
ic = Interest rate in home country.
Any imbalance in this equation leads to covered interest
arbitrage.

13. Example
• An investor based in US assumes the following
rates: spot USD/EUR = $1.2000, forward USD/EUR for 1 year
delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate =
2.5%.
• Exchange USD 1,200,000 into EUR 1,000,000.
• Buy EUR 1,000,000 worth of euro-denominated bonds.
• Sell EUR 1,025,000 via a 1 year forward contract, to receive USD
1,260,750, i.e. agree to exchange the euros back into US dollars in 1
year at today's forward price.
• At the expiry of one year, the euro-denominated bond delivers
EUR 1,025,000. and the forward contract turns the EUR 1,025,000
into USD 1,260,750. So, the earning is USD 60,750.
• The above discussion does not consider the cost of capital.
Alternatively, if the USD 1,200,000 were borrowed at 4%, USD
1,248,000 would be owed in 1 year, leaving an arbitrage profit of
1,260,750 - 1,248,000 = USD 12,750 in 1 year.

14. Reasons for imbalance
1. Change in Spot rate with interest rates and
forward rate being constant.
2. Change in interest rates of one country
without any change in the interest rate of
another country.
3. Change in the forward market rate based on
speculations.

15. Contd..
• LHS = (1+rf) RHS =F/S *(1+rh)
• LHS is not = RHS ---- Arbitrage exists
• If LHS < RHS - One would borrow foreign currency,
convert it to domestic currency at spot rate, invest
in domestic securities carrying higher interest,
covering principal and interest from this investment
at the forward rate .
• If LHS > RHS - One would borrow home currency,
convert it to foreign currency at spot rate, invest in
Foreign Securities carrying higher Interest covering
principal and interest from this investment at the
forward rate .

16. Interest Rate Parity
• Any exchange gains / losses incurred by simultaneous
purchase / sale in spot and forward markets are offset
by interest rate differential on similar assets.
RHS = [{SX(1+p)}/S] * (1+ic) = (1+ic) * (1+p)
Where, p = forward premium.
p= [(1+i$)/(1+ic)] - 1 = [(i$- ic)/(1+ic)]
• In approximated form, p = i$- ic, provides a reasonable
estimate when the interest rate differential is small.
• Interest Rate Parity hold when the Covered Interest
Arbitrage does not exist.

17. Interest Rate Differentiation
• Countries with high risk of investment have
higher interest rates. Afghanistan- unstable
government, weak economy, bad human
resource development, discourages foreign
investments.
• Stable economies provide lower interest rates.
Ex: US- safest and developed economy, has
good human resource development, has
feasible investment options

18. Post Arbitrage Correction
• Arbitrage opportunity does not remain
available for a long period. Market forces
corrects to make a balance (Fischer Equation).
• If RHS<LHS, following changes will happen:
1. Interest rates of domestic country will rise
2. Interest rates of foreign currency will fall
3. Forward rate will become high
4. Spot rate will fall.

19. Conclusion
• The International Fischer equation explains why
investments across the world are balanced.
• The differences in interest rate of different countries
occur to capture the risk profile of different
economies.
• If there are changes in the interest rates in one
country, other countries are also bound to make a
change in their interest rates to avoid huge demand
for one particular currency.
• Covered Interest Arbitrage is the exploitation of the
IRP and is used and can be used by the investors
only for the short term investments.

20. Thank You