This document discusses different types of international arbitrage opportunities and interest rate parity. It defines locational, triangular, and covered interest arbitrage, explaining how each works and how currency prices realign in response. It also explains interest rate parity, how the forward premium is determined based on interest rate differentials between countries, and factors like transaction costs that can affect parity. Diagrams and examples are provided to illustrate these concepts.

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International Financial Management
10th Edition
by Jeff Madura
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7
International Arbitrage
And Interest Rate Parity
Chapter Objectives
This chapter will:
A. Explain the conditions that will result in various forms of
international arbitrage and the realignments that will occur
in response
B. Explain the concept of interest rate parity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
International Arbitrage
1. Defined as capitalizing on a discrepancy in quoted
prices by making a riskless profit.
2. Three forms of arbitrage:
a. Locational arbitrage
b. Triangular arbitrage
c. Covered interest arbitrage

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4
Locational Arbitrage
1. 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.
2. Gains from locational arbitrage are based on the
amount of money used and the size of the
discrepancy.
3. Realignment due to locational arbitrage drives prices
to adjust in different locations so as to eliminate
discrepancies.

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5
Exhibit 7.2: Locational Arbitrage
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Triangular Arbitrage
1. Defined as currency transactions in the spot market to
capitalize on discrepancies in the cross exchange rates
between two currencies.
2. Accounting for the Bid/Ask Spread: Transaction costs
(bid/ask spread) can reduce or even eliminate the
gains from triangular arbitrage.
3. Realignment due to triangular arbitrage forces
exchange rates back into equilibrium.

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7
Exhibit 7.3 Example of Triangular Arbitrage
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8
Covered Interest Arbitrage
1. Defined as the process of capitalizing on the interest
rate differential between two countries while covering
your exchange rate risk with a forward contract.
2. Consists of two parts:
a. Interest arbitrage: the process of capitalizing on the
difference between interest rates between two countries.
b. Covered: hedging the position against interest rate risk.
3. Realignment due to covered interest arbitrage causes
market realignment.
4. Timing of realignment may require several
transactions before realignment is completed.

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9
Exhibit 7.7 Example of Covered Interest Arbitrage
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10
Exhibit 7.8 Comparing Arbitrage Strategies

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
Interest Rate Parity
In equilibrium, the forward rate differs from the spot
rate by a sufficient amount to offset the interest rate
differential between two currencies.
rate
interest
foreign
rate
interest
home
premium
forward
where
1
1
1







f
h
f
h
i
i
p
i
i
p

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Determining the Forward Premium
The relationship between the forward premium (or
discount) and the interest rate differential according to
IRP is simplified in an approximated form:
rate
interest
foreign
rate
interest
home
dollars
in
rate
spot
dollars
in
rate
forward
discount)
(or
premium
forward
where









f
h
f
h
i
i
S
F
p
i
i
S
S
F
p

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Exhibit 7.9 Illustration of Interest Rate Parity
13

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Interpreting Exhibit 7.9
Illustration of Interest Rate Parity
1. Points representing a discount: points A and B
2. Points representing a premium: points C and D
3. Points representing IRP: points A, B, C, D
4. Points below the IRP line: points X and Y
a. 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.
5. Points above the IRP line: point Z
a. U.S. investors would achieve a lower return on a foreign
investment than on a domestic one.
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Considerations When Assessing Interest
Rate Parity
1. Transaction costs
2. Political risk
3. Differential tax laws

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16
Exhibit 7.12
Relationship
between the
Interest Rate
Differential
and the
Forward
Premium