313 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH

11
C H A P T E R
International
Arbitrage
INTRODUCTION
Arbitrage is generally defined as capitalising on a discrepancy in quoted
prices as a result of the violation of an equilibrium (no-arbitrage) condition.
The arbitrage process restores equilibrium via changes in the supply of and
demand for the underlying commodity, asset or currency. The importance of
arbitrage is that no-arbitrage conditions are used for asset pricing, such that
the equilibrium price of a financial asset is the price that is consistent with
the underlying no-arbitrage condition. In this chapter we consider several
kinds of arbitrage involving foreign exchange markets, commodity markets
and money markets.
OBJECTIVES
The objectives of this chapter are:
To define arbitrage and the
no-arbitrage condition.
To describe two-point, three-point
and multi-point arbitrage in the
foreign exchange market.
To describe commodity arbitrage.
To describe covered interest
arbitrage and show how the
no-arbitrage condition can be
used to determine the forward
exchange rate.
To describe uncovered arbitrage
and introduce the concept of
carry trade.
To expose some misconceptions
of arbitrage.
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314 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 315 314 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
FIGURE 11.1 The effect of two-point arbitrage
Q
y
Q
y
D
y
S
y
D
y
S
y
S(x/y) S(x/y )
(S
A
)
0
(S
A
)
1
(SB)1
(SB)0
A B
EXAMPLE
11.1
The Reuters Monitor shows the following information about the exchange rate between the
Australian dollar and the US dollar (measured in direct quotation in both centres):
Sydney 1.7800 (AUD/USD)
New York 0.5747 (USD/AUD)
To find out whether or not there is an arbitrage opportunity, we have to check whether the
no-arbitrage condition is violated. When we invert the exchange rate in New York, we obtain
1/0.5747 = 1.7400. Thus, the no-arbitrage condition is violated in the sense that the USD is
more expensive in Sydney than in New York. Hence, arbitragers buy the US currency in
New York at 1.7400 and sell it in Sydney at 1.7800. Profit in Australian dollar per US dollar
bought and sold is
p = 1.7800 1.7400 = 0.0400
or 400 points. The effect of arbitrage is to raise the price of the USD in New York and lower it
in Sydney, until they are equal somewhere between 1.7800 and 1.7400. Suppose that at some
stage prior to the restoration of equilibrium, changes in supply and demand cause the exchange
rate to fall to 1.7700 in Sydney and rise to 1.7500 (or 0.5714 in direct quotation) in New York. In
this case, profit shrinks to
p = 1.7700 1.7500 = 0.0200
or 200 points. Eventually, the rate falls to 1.7600 in Sydney and rises to the same level (0.5682
in direct quotation) in New York. Profit at this stage is
p = 1.7600 1.7600 = 0
which means that arbitrage is not profitable because the no-arbitrage condition is restored.
curves for currency y in nancial centres A and B. Initially, the exchange rates in A and B
are (S
A
)
0
and (S
B
)
0
respectively, such that (S
A
)
0
> (S
B
)
0
. As the demand for y increases in B,
the exchange rate rises (y appreciates). Conversely, the supply of y increases in A and so the
exchange rate falls (y depreciates). This process continues until the exchange rates in both
nancial centres are equal (that is, until (S
A
)
1
= (S
B
)
1
) because this condition eliminates prot
and hence the incentive for arbitrage.
Two-point arbitrage with the bidoffer spread
So far we have shown how arbitrage works by assuming that there is no bidoffer spread. If this
assumption is relaxed, the no-arbitrage condition in this case is given by the equations
S
b,A
(x/y) = S
a,B
(x/y) 11.3
S
a,A
(x/y) = S
b,B
(x/y) 11.4
where S
b,A
(x/y) is the bid rate in A, and so on. Let us now see what happens if the equilibrium
condition is violated, such that S
b,A
(x/y) > S
a,B
(x/y). In this case the arbitrager can make profit by
buying y in B at S
a,B
(x/y) and selling it in A for S
b,A
(x/y). Arbitrage profit is the difference between
the selling rate and the buying rate, or S
b,A
(x/y) S
a,B
(x/y).
11.1 Two-point arbitrage
Also known as spatial arbitrage or locational arbitrage, two-point arbitrage arises when the
exchange rate between two currencies assumes two different values in two financial centres at
the same time. We will first consider two-point arbitrage without the bidoffer spread, then we
modify the operation to account for the spread.
Two-point arbitrage without the bidoffer spread
Given two financial centres, A and B, and two currencies, x and y, and assuming (for simplic-
ity) no transaction costs and a zero bidoffer spread, arbitrage will be triggered if the following
condition is violated:
S
A
(x/y) = S
B
(x/y) 11.1
This condition says that the exchange rate between x and y should be the same in A as in B. If
the condition is not satisfied in the sense that the exchange rate between x and y is different in
A from its level in B, then the currencies are expensive in one financial centre and cheap in the
other. Arbitragers in this case buy one of the currencies where it is cheap and sell it at profit
where it is expensive.
Consider the case when the condition is violated such that S
A
(x/y) > S
B
(x/y). This violation
means that currency y is more expensive in A than in B (or that x is cheaper in A than in B). Let
us consider the situation from the perspective of currency y. Arbitragers buy y in B and sell it
in A, making prot, p, that is given by
p = S
A
(x/y) S
B
(x/y) 11.2
The process of arbitrage restores the equilibrium condition via changes in the forces of
supply and demand. This is illustrated by Figure 11.1, which shows the supply and demand
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By starting with one unit of currency x and moving clockwise, as in Figure 11.2(a), arbitrage
involves the following steps:
1. Selling x and buying y to obtain 1/S(x/y) units of y.
2. Selling y and buying z to obtain 1/[S(x/y)S(y/z)] units of z.
3. Selling z and buying x to obtain S(x/z)/[S(x/y)S(y/z)] units of x.
Since S(x/y) > S(x/z)/S(y/z), it follows that S(x/z)/S(y/z) < S(x/y) or that S(x/z)/[S(x/y)S(y/z)] < 1.
Hence, we end up with less than one unit of x. The protable sequence must, therefore, be in
a counter-clockwise direction. This sequence, as represented by Figure 11.2(b), involves the
following steps:
1. Selling x and buying z to obtain 1/S(x/z) units of z.
2. Selling z and buying y to obtain S(y/z)/S(x/z) units of y.
3. Selling y and buying x to obtain S(y/z)S(x/y)/S(x/z) units of x.
Since S(x/y) > S(x/z)/S(y/z), it follows that S(y/z)S(x/y)/S(x/z) > 1. Thus, we end up with more
than one unit of x, and this must be the protable sequence. The possibilities for three-point
arbitrage can be summarised as follows:
If S(x/y) = S(x/z)/S(y/z), then there is no arbitrage opportunity.
If S(x/y) > S(x/z)/S(y/z), then there is a profitable arbitrage opportunity by following the
sequence x z y x.
If S(x/y) < S(x/z)/S(y/z), then there is a profitable arbitrage opportunity by following the
sequence x y z x.
Arbitrage restores the equilibrium condition via changes in the supply of, and demand
for, currencies. Let us trace what happens when S(x/y) > S(x/z)/S(y/z). Figure 11.3 shows that
the buying and selling of currencies result in changes in the forces of supply and demand, as
follows:
1. An increase in the demand for z (the supply of x), and so S(x/z) rises as shown in
Figure 11.3(a).
2. An increase in the demand for y (the supply of z), and so S(y/z) falls as shown in
Figure 11.3(b).
3. An increase in the demand for x (the supply of y), and so S(x/y) falls as shown in
Figure 11.3(c).
EXAMPLE
11.2
The exchange rate between the pound and Australian dollar (GBP/AUD) as recorded in Sydney
and London is as follows:
Sydney 0.37500.3790
London 0.37000.3740
To make profit the arbitrager will buy the Australian dollar in London at GBP0.3740 and sell it
in Sydney at GBP0.3750. Profit in pounds per Australian dollar is given by
p = 0.3750 0.3740 = 0.0010
or 10 points. Equivalently, profit is made by buying the pound in Sydney and selling it in
London.
The effect of the bidoffer spread is to reduce the protability of arbitrage, since the spread
is a transaction cost. If arbitrage is possible at the mid-rates, then we have the following:
Sydney 0.3770
London 0.3720
The arbitrager in this case buys the Australian dollar in London at GBP0.3720 and sells it in
Sydney at GBP0.3370. Arbitrage profit in this case is 0.005 or 50 points.
FIGURE 11.2 Profitable and unprofitable sequences in three-point arbitrage
z
(a) Unprofitable sequence
y
x
z
(b) Profitable sequence
y
x
11.2 Three-point and multi-point arbitrage
In this section we consider arbitrage involving more than two currencies. We start with arbitrage
involving three currencies.
Three-point arbitrage
Given three currencies (x, y and z) and making the same assumptions as in the case of two-
point arbitrage, three-point arbitrage (also called triangular arbitrage) will be triggered if the
following condition is violated:
S(x/y) =
S(x/z)
}
S(y/z)
11.5
In this case, the three exchange rates are equal across financial centres, which precludes the
possibility of two-point arbitrage (this is why the exchange rates in Equation (11.5) do not have
subscripts to indicate the financial centres where they are quoted). This condition tells us that
cross exchange rates are consistent in the sense that if we calculate one of them on the basis of
the other two, the calculated rate should be identical to the rate that is actually quoted.
Two steps are involved in three-point arbitrage: (i) checking whether or not the condi-
tion is violated (that is, whether or not the cross rates are consistent); and (ii) determining
the protable sequence. Let us assume that the no-arbitrage condition is violated such that
S(x/y) > S(x/z)/S(y/z). The protable sequence can be determined with the aid of a triangle,
placing each one of the three currencies in one of its corners (in no special order), as shown in
Figure 11.2. Determination of the protable sequence is simple. We start with one unit of any
of the three currencies and move clockwise as in Figure 11.2(a) around the triangle until we
end up where we started from, with the same currency. In this case, we end up with less than
one unit of the currency we started with, which gives the unprotable sequence. The protable
sequence will be in an anti-clockwise direction, as in Figure 11.2(b).
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318 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 319 318 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
FIGURE 11.3 The effect of three-point arbitrage
Qz
S(x/z)
Dz
Sz
(a)
Qz
S(y/z)
Dz
Sz
(b)
Qy
S(x/y)
Dy
Sy
(c)
W
e have presented three-point arbitrage as a risk-free
operation, because all of the decision variables (three
exchange rates) are known at the time the decision is
made. However, Kollias and Metaxas argue that three-point
arbitrage involves some degree of risk due to the effect of
slippages in currency quotes.
1
By using high-frequency, tick-by-tick data on the
exchange rates they found that arbitrage opportunities
do exist. However, they also found that the exploitation
of such opportunities involves a degree of risk that can
adversely affect realised returns.
R
E
S
E
A
R
C
H
THE PROFITABILITY OF THREE-POINT ARBITRAGE
1
C. Kollias and K. Metaxas, How Efcient are FX Markets? Empirical Evidence of Arbitrage Opportunities Using High-Frequency Data,
Applied Financial Economics, 11, 2001, pp. 43544.
The following exchange rates are quoted in Sydney, Auckland and Hong Kong:
S(HKD/AUD) 4.1548
S(NZD/AUD) 1.2052
S(HKD/NZD) 3.5825
To find out whether or not there is a possibility for three-point arbitrage, we have to check the
consistency of the cross rates (the validity of the no-arbitrage condition). S(HKD/NZD) can be
calculated from the other two rates as
S(HKD/NZD) =
S(HKD/AUD)
}}
S(NZD/AUD)
=
4.1548
}
1.2052
= 3.4474
Hence, the equilibrium condition is violated, implying a possibility for three-point arbitrage.
First, try the sequence HKD NZD AUD HKD, starting with one unit of HKD:
1. Sell HKD1.0000 for NZD to obtain (1/3.5825 = 0.2791) units of NZD.
2. Sell NZD0.2791 for AUD to obtain (0.2791/1.2052 = 0.2316) units of AUD.
3. Sell AUD0.2316 for HKD to obtain (0.2316 4.1548 = 0.9623) units of HKD.
Obviously, this is not the profitable sequence. Now, try the opposite sequence, starting with one
unit of HKD:
1. Sell HKD1.0000 for AUD to obtain (1/4.1548 = 0.2407) units of AUD.
2. Sell AUD0.2407 for NZD to obtain (0.2407 1.2052 = 0.2901) units of NZD.
3. Sell NZD0.2901 for HKD to obtain (0.2901 3.5825 = 1.0392) units of HKD.
This is obviously the profitable sequence. If S(HKD/NZD) = 3.4474, then there is no possibility
for three-point arbitrage because this rate is consistent with the others. At this stage we have:

S(HKD/AUD)
}}}
S(HKD/NZD)S(NZD/AUD)
=
4.1548
}}
3.4474 1.2052
= 1.0000
and

S(NZD/AUD)S(HKD/NZD)
}}}
S(HKD/AUD)
=
1.2052 3.4474
}}
4.1548
= 1.0000
which shows that there is no protable sequence.
EXAMPLE
11.3
Multipoint arbitrage
Arbitrage involving four, five or more currencies can take place. However, three-point arbitrage
is sufficient to establish consistent exchange rates, eliminating the profitability of multi-point
arbitrage. In the case of three-point arbitrage involving currencies x, y and z, the no-arbitrage
condition may be written as
S(x/y)S(y/z)S(z/x) = 1 11.6
If four currencies are involved (x
1
, x
2
, x
3
and x
4
), then we have four-point arbitrage, in which
case the no-arbitrage condition is
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320 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 321 320 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
S(x
1
/x
2
)S(x
2
/x
3
)S(x
3
/x
4
)S(x
4
/x
1
) = 1 11.7
and when n currencies are involved, the no-arbitrage condition is
S(x
1
/x
2
)S(x
2
/x
3
)S(x
3
/x
4
)S(x
n1
/x
n
)S(x
n
/x
1
) = 1 11.8
EXAMPLE
11.4
Consider the following exchange rates:
S(AUD/USD) 1.8811
S(JPY/USD) 132.68
S(JPY/GBP) 189.24
S(GBP/EUR) 0.6125
S(EUR/AUD) 0.6086
The no-arbitrage condition in this case is
S(AUD/USD)S(USD/JPY)S(JPY/GBP)S(GBP/EUR)S(EUR/AUD) = 1
which gives
1.8811
1
}
132.68
189.24 0.6125 0.6086 = 1.000
Because the no-arbitrage condition is not violated there is no possibility for profitable five-point
arbitrage. We can actually check that this is the case by working out the process step by step,
starting with one AUD and moving as shown in Figure 11.4. In this case, we have a pentagon
rather than a triangle. The results of the calculations are displayed in the following table, which
shows that starting with one Australian dollar we end up with one Australian dollar no matter
which direction we move (try the same exercise by starting with one pound). You may want to
check for yourself that there is no possibility for three-point arbitrage either, using all possible
currency combinations (taking three currencies at a time).
CLOCKWISE
TRANSACTION END CURRENCY NUMBER OF UNITS
AUD USD USD 0.5316
USD JPY JPY 70.53
JPY GBP GBP 0.3727
GBP EUR EUR 0.6085
EUR AUD AUD 1.0000
ANTICLOCKWISE
AUD EUR EUR 0.6086
EUR GBP GBP 0.3728
GBP JPY JPY 70.55
JPY USD USD 0.5317
USD AUD AUD 1.0000
FIGURE 11.4 Five-point arbitrage
GBP
EUR
AUD
USD
JPY
(a) Clockwise
AUD
USD
JPY GBP
EUR
(b) Anti-clockwise
11.3 Commodity arbitrage
The no-arbitrage condition in the case of commodity arbitrage is the law of one price (LOP),
which stipulates that, in the absence of frictions such as shipping costs and tariffs, the price
of a commodity expressed in a common currency is the same in every country. Commodity
arbitrage is conducted by buying a commodity in a market where it is cheap and selling it in a
market where it is more expensive. The LOP can be written as
P
i
= S P
i

*
11.9
where P
i
is the domestic price of commodity i, P
i

*
is its foreign price and S is the exchange rate
expressed as the number of units of the domestic currency per one unit of the foreign currency.
Thus, S P
i

*
is the domestic currency equivalent of the foreign price of the commodity. Likewise,
P
i
/S is the foreign currency equivalent of the domestic currency price of the commodity.
When arbitragers buy a commodity in a market where it is cheap and sell it where it is more
expensive they make prot as the difference between the selling price and the buying price.
This activity leads to a rise in the price of the commodity in the market where it is cheap and
a decline in its price in the market where it is expensive until prot is eliminated and the no-
arbitrage condition is restored.
Figure 11.5 shows how commodity arbitrage works, starting from a disequilibrium posi-
tion described by the inequality P
i
> SP
i
*
. Initially, the domestic currency prices of commodity i
abroad and at home are SP
i0
*
and P
i0
respectively. Arbitragers, then, buy the commodity where
it is cheap (in the foreign market), leading to an increase in demand and a shift in the demand
curve. They sell the commodity in the domestic market, leading to an increase in supply. Thus,
the price rises in the foreign market and falls in the domestic market, until the former reaches
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The price of commodity i in Australia is AUD100 and the exchange rate (AUD/USD) is 1.80.
The LOP implies that the equilibrium US price is USD56, because at this price the equilibrium
condition represented by equation (11.9) is not violated, implying no possibility for profitable
arbitrage. This is because the selling price and the buying price measured in the same cur-
rency (P
i
and S P
i

*
respectively) are equal, which produces zero arbitrage profit. If the US price is
USD50, then P
i
S P
i

*
> 0, implying that the no-arbitrage condition is violated, and that there is
a possibility of profitable arbitrage. Arbitragers make profit by buying the commodity where it
is cheap (the United States), paying USD50 (or AUD90), and selling it in Australia at AUD100.
Net arbitrage profit is then given by P
i
S P
i

*
= AUD10 per unit of the commodity.
EXAMPLE
11.5
FIGURE 11.5 The effect of commodity arbitrage
Q
i
Q
i
D
0 D
0
D
1
S
1
S
0
S
0
SP
i
Pi
P
i 0
P
i 1
*
1
SP
i
*
1
SP
i
*
0
(a) Domestic market (b) Foreign market
SP
i1
*
and the latter reaches P
i1
, which are equal. At this point, arbitrage prot is eliminated and
the equilibrium condition is restored.
In reality, however, commodity arbitrage is not as effective as to bring prices into equality
and substantial cross-border differences in prices exist. Several reasons can be presented
to explain deviations from the LOP, including transportation costs, differences in taste and
differences in quality. Remember that for the LOP to work, we must consider exactly similar
products in the absence of transportation costs. But even these conditions may not be adequate.
Just imagine buying a Big Mac in Melbourne and selling it in New York: by the time it gets
there no one would want to buy it. There are, however, real episodes of commodity arbitrage.
In the early 1990s, for example, quantitative restrictions on the imports of alcoholic beverages
to the United Kingdom from France were relaxed in the spirit of the European single market.
Given that beer was cheaper to buy in France, the English found it protable to go across the
Channel, buy a vanload of French beer and sell it at prot in England. French beer was sold by
individuals as far north as Shefeld and Newcastle.
S
ince 1986, The Economist magazine has used the
price of a homogenous product, the Big Mac, to show
that there are cross-border differences in prices (when
measured in the same currency) and to use these prices to
calculate the level of exchange rates compatible with the
no-arbitrage condition.
The idea is very simple. Big Mac prices are recorded in
a number of countries, then converted into US dollars and
compared. The exchange rate compatible with the LOP (per
US dollar) is subsequently calculated by dividing the price of
a Big Mac in any country by the price in the United States.
The deviation of the actual rate from the no-arbitrage
rate is calculated and used to indicate the extent of the
overvaluation or undervaluation of the dollar (overvaluation
is present when the actual rate is higher than the
no-arbitrage rate, and vice versa).
I
N

P
R
A
C
T
I
C
E
USING THE LOP FOR CURRENCY VALUATION
11.4
While the LOP typically applies to the prices of individual commodities (such as a Big Mac),
there is no reason why it cannot be applied to baskets of goods whose prices are measured in
different currencies. In this case, the LOP can be written as
P = SP
*
11.10
which is the same as equation (11.9) except that it is written in terms of the prices of baskets of
commodities, P and P
*
, and not the prices of individual commodities, P
i
and P
i

*
. If P and P
*
are
taken to be the general price levels at home and abroad, then Equation (11.10) may be taken to
represent purchasing power parity, which we studied in Chapter 4.
Covered interest arbitrage
Covered interest arbitrage is triggered by the violation of the covered interest parity (CIP)
condition, which describes the equilibrium relation between the spot exchange rate, the for-
ward exchange rate, domestic interest rates and foreign interest rates. In essence, CIP is an
application of the law of one price to financial markets, postulating that, when foreign exchange
risk is covered in the forward market, the rate of return on a domestic asset must be equal to
that on a foreign asset with similar characteristics. If this is not the case, then covered interest
arbitrage is set in motion and continues until the resulting changes in the forces of supply and
demand (for the underlying assets) lead to a restoration of the no-arbitrage condition repre-
sented by CIP.
The CIP condition
Consider an investor who has initial capital, K, and faces two alternatives: (i) domestic
investment, whereby the investor buys domestic assets, earning the domestic interest rate, i;
and (ii) foreign investment, whereby the investor converts the domestic currency into for-
eign currency to buy foreign assets, earning the foreign interest rate, i
*
. Since the domestic
investment does not involve currency conversion, it does not involve foreign exchange risk
(the risk arising from changes in the spot exchange rate). On the other hand, the foreign
investment produces exposure to foreign exchange risk, but this exposure can be covered by
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Let us assume that there are no restrictions on the movement of capital and that there are
no transaction costs. We also assume that agents are risk-neutral, in the sense that they are
indifferent between holding domestic and foreign assets if these assets offer equal returns.
The equilibrium condition that precludes the possibility of protable arbitrage is that the two
investments must be equally protable, in the sense that they provide the same domestic
currency amount of capital plus interest. Hence
K(1 + i) =
K
}
S
(1 + i
*
)F 11.11
By expressing the condition in terms of one unit of the domestic currency, we obtain
(1 + i) =
F
}
S
(1 + i) 11.12
This condition (CIP) tells us that gross domestic return is equal to gross covered foreign return.
The left-hand side of equation (11.12) represents gross domestic return: it is gross because it
includes the amount invested (one unit of the domestic currency) and the interest earned, i.
Since F/S = 1 + f , where f is the forward spread, it follows that
(1 + i) = (1 + f)(1 + i
*
) 11.13
By simplifying equation (11.13), ignoring the term i
*
f, we obtain the approximate CIP condition
i i
*
= f 11.14
which tells us that in equilibrium the interest differential must be equal to the forward spread.
Equation (11.14) implies that the currency offering the higher interest rate must sell at a forward
discount, and vice versa. This is because if i > i
*
, then f > 0, which means that the foreign cur-
rency (offering a lower interest rate) sells at a forward premium whereas the domestic currency
(offering a higher interest rate) sells at a forward discount. If, on the other hand, i < i
*
, then
f < 0, implying that the foreign currency sells at a discount while the domestic currency sells at
a premium.
Covered arbitrage without bidoffer spreads
Covered interest arbitrage consists of going short on (borrowing) one currency and long on
(investing in) another currency, while covering the long position via a forward contract (selling
the currency forward). Upon the maturity of the investment (and the forward contract) the pro-
ceeds are converted at the forward rate and used to repay the loan (covering the short position).
The difference between the proceeds from the investment and the loan repayment (principal
plus interest) is net arbitrage profit, or the covered margin. For arbitrage to be profitable the
covered margin must be positive. This process is illustrated in Figure 11.7.
Depending on the conguration of exchange and interest rates, an arbitrager may choose
to arbitrage from the domestic to a foreign currency (taking a short position on the domes-
tic currency and a long position on the foreign currency) or vice versa. The choice depends
on which sequence produces prot or positive covered margin. For a given conguration of
exchange and interest rates, if arbitrage is protable in one direction it must produce a loss
in the opposite direction. In the following descriptions the spot and forward exchange rates
are measured in direct quotation as the price of one foreign currency unit (domestic/foreign).
selling the foreign currency (buying the domestic currency) forward. Foreign exchange risk
is eliminated because the forward exchange rate is known in advance, although it is used to
settle transactions involving delivery of the currencies some time in the future. Thus, the
investor knows in advance the domestic currency value of her foreign investment. If the posi-
tion is not covered in the forward market, the investor has to wait until maturity and apply
the spot exchange rate prevailing then to determine the domestic currency value of the foreign
investment.
Suppose that we are considering a one-period investment starting with the acquisition of a
nancial asset (for example, a deposit) and ending with the maturity of this asset (Figure 11.6).
When the investor chooses the domestic investment, the invested capital is compounded at
the domestic interest rate, and the investor ends up with the initial capital plus interest income,
that is, K (1 + i). If the investor chooses the foreign investment, she converts the initial capital to
foreign currency at the current spot exchange rate, obtaining K/S units of the foreign currency,
where S is measured as domestic currency units per one unit of the foreign currency. If K/S worth
of the foreign currency is invested in foreign assets, this capital is compounded for one period
at the foreign interest rate, such that the foreign currency value of the investment on maturity
is (K/S)(1 + i
*
). The domestic currency value of this investment is obtained by converting this
amount into the domestic currency at the forward rate, F, to obtain F (K/S)(1 + i
*
).
FIGURE 11.6 Return on domestic and foreign investment (with covered position)
Converting at
spot rate
Investor
(K)
Foreign
investment
Investing in
foreign assets
Reconverting at
forward rate
K
S
K
S
(1 + i*)
KF
S
(1 + i*) K(1 + i)
Domestic
investment
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326 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 327 326 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
This amount is reconverted into domestic currency at the forward rate, F, to obtain (F/S)(1 + i
*
)
domestic currency units.
The value of the loan plus interest is (1 + i) domestic currency units.
The covered margin, p, is the difference between the domestic currency value of the
proceeds and loan repayment, which gives
p =
F
}
S
(1 + i) (1 + i
*
) 11.15
or approximately
p = i
*
i + f 11.16
Equation (11.16) tells us that the covered margin on arbitrage from the domestic to a foreign cur-
rency consists of the interest rate differential (foreign less domestic) and the forward spread.
Arbitrage from a foreign to the domestic currency consists of the following steps:
The arbitrager borrows foreign currency funds at the foreign interest rate, i
*
. For simplicity
we again assume that the amount borrowed is one foreign currency unit.
Borrowed funds are converted at the spot exchange rate, S, obtaining S domestic currency
units. This amount is invested at the domestic interest rate, i.
The domestic currency value of the invested amount at the end of the investment period is
S(1 + i).
This amount is reconverted into the foreign currency at the forward rate, F, to obtain (S/F)
(1 + i) foreign currency units.
The value of the loan plus interest is (1 + i*) foreign currency units.
The covered margin is again the difference between the domestic currency value of the
proceeds and loan repayment, which gives
p =
S
}
F
(1 + i) (1 + i
*
) 11.17
or approximately
p = i i
*
f 11.18
Equation (11.18) tells us that the covered margin on arbitrage from the foreign to the domestic
currency consists of the interest rate differential (domestic less foreign) and the negative of the
forward spread.
The interest parity forward rate
The no-arbitrage condition is obtained when the covered margin is zero. By substituting p = 0
in equation (11.15) or (11.17), we obtain

}
F = S
F

1 + i
}
1 + i
*

G
11.19
where
}
F is the particular value of the forward rate that is consistent with the no-arbitrage condi-
tion, which we may call the interest parity forward rate. If CIP holds then
}
F = F.
Suppose that you approached your banker, requesting a quote for the forward rate between
the domestic currency and a foreign currency, perhaps because you want to buy the foreign
currency forward to cover future payables. The banker may not know what CIP is, but he will
Arbitrage, however, does not have to involve the domestic currency, as two foreign currencies
may provide a protable arbitrage opportunity.
Arbitrage from the domestic to a foreign currency consists of the following steps:
The arbitrager borrows domestic currency funds at the domestic interest rate, i. For simplicity
we assume that the amount borrowed is one domestic currency unit.
Borrowed funds are converted at the spot exchange rate, S, obtaining 1/S foreign currency
units. This amount is invested at the foreign interest rate, i
*
.
The foreign currency value of the invested amount at the end of the investment period is
(1/S)(1 + i
*
).
FIGURE 11.7 Covered interest arbitrage without bidoffer spreads
Borrowing
domestic
currency
Converting
at spot rate
Investing at
foreign rate
1 unit
1
S
Loan
repayment
Loan
repayment
Borrowing
foreign
currency
Converting
at spot rate
Reconverting at
forward rate
Reconverting at
forward rate
Investing at
domestic rate
Covered margin Covered margin
1 + i*
Domestic Foreign Foreign Domestic
1
S
(1 + i*)
F
S
(1 + i*)
F
S
(1 + i*) (1 + i )
S
F
(1 + i ) (1 + i*)
S
F
(1 + i)
S(1 + i )
1 + i
S
1 unit
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328 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 329 328 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
Covered arbitrage with bidoffer spreads
To reconsider covered arbitrage in the presence of bidoffer spreads in both exchange and
interest rates we have to remember that a price-taker in the foreign exchange market (like our
arbitrager) buys at the (higher) offer exchange rate and sells at the (lower) bid exchange rate of
the market-maker (the banker). A price-taker in the money market borrows at the (higher) offer
interest rate and lends at the (lower) bid interest rate of the market-maker. Covered arbitrage in
the presence of bidoffer spreads is illustrated in Figure 11.8.
Arbitrage from the domestic currency to a foreign currency consists of the following steps:
The arbitrager borrows domestic currency funds at the domestic offer interest rate, i
a
.
Borrowed funds are converted into the foreign currency at the spot offer rate, S
a
, obtaining
1/S
a
foreign currency units. This amount is invested at the foreign bid interest rate, i
b

*
.
The foreign currency value of the invested amount at the end of the investment period is
(1/S
a
)(1 + i
b

*
).
This amount is reconverted into the domestic currency at the bid forward rate, F
b
, to obtain
(F
b
/S
a
)(1 + i
b

*
) domestic currency units.
The value of the loan plus interest per unit of the domestic currency is (1 + i
a
).
The covered margin in this case is
p =
F
b
}
S
a
(1 + i
b

*
) (1 + i
a
) 11.20
Since F
b
/S
a
= (1 + f )/(1 + m), where f is the forward spread and m is the bidoffer spread, it fol-
lows that
p = i
b

*
i
a
+ f m 11.21
By comparing Equations (11.16) and (11.21), we can see that the covered margin is lower if we
allow for the bidoffer spreads. This is simply because bidoffer spreads are transaction costs.
Arbitrage from a foreign currency to the domestic currency consists of the following steps:
The arbitrager borrows foreign currency funds at the foreign offer interest rate, i
a

*
.
Borrowed funds are converted into the domestic currency at the spot bid rate, S
b
, obtaining
S
b
domestic currency units. This amount is invested at the domestic bid interest rate, i
b
.
open his manual to search for a formula that gives him an expression for the forward rate. This
formula would look like Equation (11.19). Why would the banker use this formula to calculate
the forward rate? Simply because if the banker chose any other forward rate, you can simply
make (riskless) prot out of your banker by indulging in covered arbitrage. The following
example explains the situation.
EXAMPLE
11.6
Suppose that you asked your banker to quote a one-year forward rate on the pound, which he
does, giving you the following information:
One-year forward rate (AUD/GBP) 2.6500
Spot rate (AUD/GBP) 2.7500
One-year AUD interest rate 8%
One-year GBP interest rate 4%
You observe immediately that the pound is selling at a forward discount because the forward
rate is lower than the spot rate. Let us see what happens if you try to indulge in covered arbi-
trage, starting with arbitrage from the pound to the Australian dollar:
Borrow GBP1000 (or any other amount).
Convert the pound spot at 2.75 to obtain AUD2750 (1000 2.75).
Invest the AUD amount at 8 per cent for one year. At the end of the year, you will have
AUD2970 (2750 (1 + 0.08)).
Reconvert the AUD proceeds at the forward rate to pounds to obtain GBP1120.8
(2970/2.65).
The loan repayment that you have to make is GBP1040 (1000 (1 + 0.04)).
Net arbitrage profit is GBP80.8 (= 1120.8 1040).
Notice that this profit is made without bearing any risk, since all of the decision variables (includ-
ing the forward rate) are known at the time you decided to indulge in this operation. Now, let
us see what happens if instead you decided to indulge in arbitrage from the Australian dollar to
the pound:
Borrow AUD1000 (or any other amount).
Convert the Australian dollar spot at 2.75 to obtain GBP363.6 (1000/2.75).
Invest the GBP amount at 4 per cent for one year. At the end of the year, you will have
GBP378.1.
Reconvert the GBP proceeds at the forward rate to Australian dollars to obtain AUD1002
(3781 2.65).
The loan repayment that you have to make is AUD1080 (1000 (1 + 0.08)).
Net arbitrage loss is AUD78.0 (= 1080 1002).
In this case you make a loss. Now assume that the banker quoted a forward rate of 2.8558. If you
indulge in arbitrage from the pound to the Australian dollar at this forward rate, you will (after
reconversion) obtain GBP1040 (2970/2.8558), in which case your arbitrage profit is zero. If you
go from the Australian dollar to the pound you obtain AUD1080 (378.1 2.8558). Again, your
profit is zero. Your banker will always quote you this rate so that you will not make profit out of
him. This rate is calculated from equation (11.19) as
2.75 F
1.08
}
1.04
G = 2.8558
You make profit if the forward rate is 2.65 because this rate is not consistent with the no- arbitrage
condition (but 2.8558 is). If the quoted forward rate is not consistent with the no-arbitrage condi-
tion you will make profit in one direction and loss in the other (exactly as in the case of two-point
and three-point arbitrage). How do you know which way to go? Very simply by calculating the
covered margin, which must be positive for arbitrage to be profitable.
We have to be very careful about the deannualisation of interest rates when these calcula-
tions are carried out. In this example we did not deannualise interest rates because we used a
time horizon of one year. If, on the other hand, we used a horizon of six months, deannualised
interest rates on the two currencies would be 4 and 2 per cent respectively. In general, we dean-
nualise interest rates by dividing by (12/N) where N is the time horizon in months.
Example 11.6 continued
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330 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 331 330 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
The domestic currency value of the invested amount at the end of the investment period is
S
b
(1 + i
b
).
This amount is reconverted into the foreign currency at the offer forward rate, F
a
, to obtain
(S
b
/F
a
)(1 + i
b
) foreign currency units.
The value of the loan plus interest is (1 + i
a
*
) foreign currency units.
The covered margin in this case is
p =
S
b
}
F
a
(1 + i
b
) (1 + i
a

*
) 11.22
FIGURE 11.8 Covered interest arbitrage with bidoffer spreads
Borrowing
domestic
currency
Converting at
spot offer rate
Investing at
foreign bid rate
1 unit
1
Sa
Loan
repayment
Loan
repayment
Borrowing
foreign
currency
Converting at
spot bid rate
Reconverting at
forward bid rate
Reconverting at
forward offer rate
Investing at
domestic bid rate
Covered margin Covered margin
Domestic Foreign Foreign Domestic
Fb
Sa
1 + ia
Sb
1 unit
Sb(1 + ib)
1
Sa
(1 + i*) b
(1 + i*) b
Sb
Fa
(1 + ib) (1 + i*) a
Fb
Sa
(1 + i*)(1 + ia) b
Sb
Fa
(1 + ib)(1 + ia
*)
EXAMPLE
11.7
You request your banker to quote a one-year forward rate on the pound, which he does. The
following information is available:
One-year forward rate (AUD/GBP) 2.64502.6550
Spot rate (AUD/GBP) 2.74502.7550
One-year AUD interest rate 7.758.25
One-year GBP interest rate 3.754.25
Consider arbitrage from the pound to the Australian dollar:
Borrow GBP1000 (or any other amount).
Convert the pound spot at 2.7450 to obtain AUD2745 (1000 2.7450).
Invest the AUD amount at 7.75 per cent for one year. At the end of the year, you will have
AUD2958 (2745 (1 + 0.0775)).
Reconvert the AUD proceeds at the offer forward rate into pounds to obtain GBP1114
(2958/2.6550).
The loan repayment that you have to make is GBP1042.5 (1000 (1 + 0.0425)).
Net arbitrage profit is GBP71.50 (= 1114 1042.50).
which is less than was obtained in the previous example. Now, let us see what happens if instead
you indulge in arbitrage from the Australian dollar to the pound:
Borrow AUD1000 (or any other amount).
Convert the Australian dollar spot at 2.7550 to obtain GBP363 (1000/2.7550).
Invest the GBP amount at 3.75 per cent for one year. At the end of the year, you will have
GBP377.
Reconvert the GBP proceeds at the bid forward rate into Australian dollar to obtain
AUD997 (377 2.6450).
The loan repayment that you have to make is AUD1082.50 (1000 (1 + 0.0825)).
Net arbitrage loss is AUD85.5 (= 997 1082.50).
The loss incurred in this case is greater than that incurred in the previous case.
11.5
Since S
b
/F
a
= 1/[(1 + m)(1 + f )], it follows that
p = i
b
i
a

*
f m 11.23
which again shows that the covered margin would be lower if the bidoffer spreads are
allowed for.
Uncovered interest arbitrage
Uncovered arbitrage is triggered by the violation of the uncovered interest parity (UIP) con-
dition. It is described as uncovered because, unlike covered arbitrage, the long currency position
is not covered in the forward market but rather left uncovered or open. This means that the
proceeds of an investment in foreign currency assets are reconverted into the domestic currency
(or vice versa) at the spot exchange rate prevailing on the maturity date of the investment rather
than at the forward rate determined in advance. Thus, foreign exchange risk is present, which
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332 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 333 332 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
investor chooses foreign investment, he or she will convert the initial capital into foreign cur-
rency at the current spot exchange rate, S, obtaining K/S units of the foreign currency, where
S is measured as domestic currency units per one unit of the foreign currency. If K/S worth of
the foreign currency is invested in foreign assets, this capital is compounded for one period at
the foreign interest rate, i
*
, such that the foreign currency value of the investment on maturity
is (K/S)(1 + i
*
). The expected domestic currency value of this investment is obtained by recon-
verting this amount into the domestic currency at the expected spot rate, S
e
, to S
e
(K/S)(1 + i
*
).
The two alternatives are described in Figure 11.9.
Again, we assume that there are no restrictions on the movement of capital and no trans-
action costs. Assume also that traders are risk-neutral, in the sense that they are indifferent
between holding domestic and foreign assets if these assets offer the same (expected) return.
The equilibrium condition that precludes the possibility of protable arbitrage is that the two
investments must be equally attractive, offering the same return. Hence
K(1 + i) =
K
}
S
(1 + i
*
)S
e
11.24
or
1 + i =
S
e
}
S
(1 + i
*
) 11.25
which says that gross domestic return must be equal to gross foreign uncovered return.
means that it is more like speculation than arbitrage. This is why another name for this activity
is carry trade.
There are, however, reasons why this activity is called arbitrage. The term uncovered arbi-
trage is used so that it can be the counterpart of covered arbitrage. Moreover, if arbitragers
rmly believed in their exchange rate expectations, then they would behave as if there was no
foreign exchange risk. And if the operation involves a pair of currencies with a xed or highly
stable exchange rate, then foreign exchange risk will be absent or minimal, in which case the
term arbitrage is appropriate. Then there is the view that arbitrage is not really a risk-free
operation, but this is a controversial proposition that we will put aside.
Deriving the UIP condition
The UIP condition can be derived by combining CIP with the unbiased efficiency condition, which
stipulates (in its strongest form) that the future spot rate is equal to the current forward rate. Thus,
we can obtain UIP if the forward rate (forward spread) in CIP is replaced with the expected spot rate
(expected percentage change in the spot rate). This difference in specification reflects the difference
between covered arbitrage, which is based on the forward rate (or forward spread), and uncovered
arbitrage, which is based on the expected spot rate (or expected change in the spot rate).
Alternatively, UIP can be derived directly as follows. Consider an investor with initial
capital, K, who is facing two alternatives: (i) domestic investment whereby the investor buys
domestic assets, earning the domestic interest rate, i; and (ii) foreign investment whereby the
investor converts the domestic currency into foreign currency to buy foreign assets, earning
the foreign interest rate, i
*
. The foreign investment produces exposure to foreign exchange risk,
which in this case is not covered, as the investor leaves the position open. Foreign exchange
risk is present because, unlike the forward rate, the spot exchange rate used to reconvert the
proceeds of foreign investment into the domestic currency is not known in advance (that
is, prior to the maturity of the investment). In this case, the investor acts upon the spot rate
expected to prevail on the maturity date of the investment, not knowing in advance the dom-
estic currency value of his or her foreign investment on maturity.
Consider a one-period investment starting with the acquisition of a nancial asset (for
example, a bank deposit) at time 0 and ending with the maturity of this asset at time 1. When
the investor chooses domestic investment, the invested capital is compounded at the domestic
interest rate, and the investor ends up with the initial capital plus interest, which is K (1 + i)
where i is the interest earned by holding the domestic asset between time 0 and time 1. If the
C
IP has two important practical business implications
pertaining to two activities: hedging and short-term
investment/nancing.
The rst implication is that if CIP holds then there is
no difference between the effectiveness of forward hedging
and money market hedging (borrowing and lending in the
money market). This is because money market hedging
creates a synthetic forward contract with an implicit
forward rate that, under CIP, is equal to the forward rate
quoted in the market. In this case, money market and
forward market hedging produce identical results in terms
of the domestic currency values of payables and receivables
under the two modes of hedging.
The second implication pertains to nancing and
investment decisions. It implies that there is no difference
between nancing or investing in the domestic currency
and in a foreign currency while covering the position
in the forward market. This is because the two modes
of nancing/investment give exactly the same cost of
funding/rate of return if CIP holds.
I
N

P
R
A
C
T
I
C
E
SOME PRACTICAL BUSINESS IMPLICATIONS OF CIP
FIGURE 11.9 Return on domestic and foreign investment (with uncovered position)
Converting at
current spot rate
Investor
(K)
Foreign
investment
Investing in
foreign assets
Reconverting at
expected spot rate
K
S
K
S
(1 + i *)
KS
e
S
(1 + i *) K(1 + i )
Domestic
investment
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The value of the loan plus interest is (1 + i) domestic currency units.
The uncovered margin, p, is the difference between the domestic currency value of the
proceeds and loan repayment, which gives
p =
S
1
}
S
0
(1 + i
*
) (1 + i) 11.28
or approximately
p = i i
*
+ S
.
11.29
Since S
e
/S = 1 + S

e
, where S

e
is the expected percentage change in the exchange rate, it
follows that
1 + i = (1 + S

e
)(1 + i
*
) 11.26
Equation (11.26) can be used to derive an approximate UIP condition by ignoring the term i
*
S

e

on the assumption that it is too small. The approximate condition is
i i
*
= S

e
11.27
Equation (11.27) implies that the currency offering the higher interest rate must be expected to
depreciate, and vice versa. This is because if i > i
*
, then S

e
> 0, which means that the foreign
currency (offering a lower interest rate) is expected to appreciate, while the domestic currency
(offering a higher interest rate) is expected to depreciate. If, on the other hand, i < i
*
, then
S

e
< 0, implying that the foreign currency is expected to depreciate, while the domestic currency
is expected to appreciate. This must be a necessary condition for equilibrium because no inves-
tor wants to hold a currency that offers a low interest rate and is expected to depreciate, while
everyone wants to hold a currency that offers a high interest rate and is expected to appreciate.
Uncovered interest arbitrage without bidoffer spreads
Uncovered interest arbitrage consists of taking a short position on (that is, borrowing) a currency,
and a corresponding long position on (that is, investing in) another currency (Figure 11.10) with-
out covering the long position. One of the two currencies may be the domestic currency and the
other a foreign currency (although this is not necessarily the case). We will illustrate uncovered
arbitrage by taking time 0 to be the time at which the operation is initiated and time 1 to be the
time at which the investment matures and the short position is covered.
Arbitrage from the domestic to a foreign currency consists of the following steps:
The arbitrager borrows domestic currency funds at the domestic interest rate, i. For simplicity
we assume that the amount borrowed is one domestic currency unit.
Borrowed funds are converted at the spot exchange rate, S
0
, obtaining 1/S
0
foreign currency
units. This amount is invested at the foreign interest rate, i
*
.
The foreign currency value of the invested amount at the end of the investment period is
(1/S
0
)(1 + i
*
).
This amount is reconverted into the domestic currency at the spot exchange rate prevailing
at time 1, S
1
, to obtain (S
1
/S
0
)(1 + i
*
) domestic currency units.
The current exchange rate between the Australian and US dollars is 1.80 (AUD/USD) and the
three-month interest rates on the Australian and US currencies are 6 and 4 per cent p.a. respec-
tively. If UIP holds, the level of the exchange rate expected to prevail three months from now can
be calculated from the (deannualised) interest rate differential as follows:
i i
*
=
6
}
4

4
}
4
= 0.5
The US dollar should appreciate by 0.5 per cent. The level of the exchange rate three months
from now should be
1.005 1.80 = 1.809
EXAMPLE
11.8
FIGURE 11.10 Uncovered interest arbitrage without bidoffer spreads
Borrowing
domestic
currency
Converting
at spot rate
Investing at
foreign rate
1 unit
Loan
repayment
Loan
repayment
Borrowing
foreign
currency
Converting
at spot rate
Reconverting at
spot rate
Reconverting at
spot rate
Investing at
domestic rate
Uncovered margin Uncovered margin
1 + i*
1
S0
1
S0
(1 + i*)
S1
S0
(1 + i*)
S1
S0
(1 + i*)(1 + i )
S0
S1
(1 + i )(1 + i*)
S0
S1
(1 + i)
S0(1 + i)
1 + i
S0
1 unit
Domestic Foreign Foreign Domestic
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where S

is the percentage change in the exchange rate between 0 and 1. Equation (11.29) tells us
that the uncovered margin on arbitrage from the domestic to a foreign currency consists of the
interest rate differential and the percentage change in the exchange rate.
Arbitrage from a foreign to the domestic currency consists of the following steps:
The arbitrager borrows foreign currency funds at the foreign interest rate, i
*
. For simplicity
we again assume that the amount borrowed is one foreign currency unit.
Borrowed funds are converted at the spot exchange rate, S
0
, obtaining S
0
domestic currency
units. This amount is invested at the domestic interest rate, i.
The domestic currency value of the invested amount at the end of the investment period is
S
0
(1 + i).
This amount is reconverted into the foreign currency at the spot rate, S
1
, to obtain
(S
0
/S
1
)(1 + i) foreign currency units.
The value of the loan plus interest is (1 + i*) foreign currency units.
The uncovered margin is the difference between the domestic currency value of the pro-
ceeds and loan repayment, which gives
C
arry trade is essentially another name for uncovered
arbitrage, which may be a better name, since it is
a risky operation. This operation became very popular
as the interest rate on the yen declined to near zero in
the recent past, and this is why it came to be known as
yen carry trade where the yen is described as being the
funding currency and a high-interest currency, such as the
Australian dollar, is known as the target currency.
On the protability of carry trade, Burnside et al.
conclude that although the operation produces very large
Sharpe ratios (which is a measure of return relative to
risk), the amount of money produced by carry trade is
rather small because of transaction costs and price pressure
limits.
1
They nd that carry trade produces higher Sharpe
ratios than that of the Standard and Poors 500 index even
after taking into account transaction costs. However, they
point out that the pay-off in terms of the sums of money
obtainable from carry trade is relatively small.
In their study of the protability of carry trade,
Gyntelberg and Romolona use the yen and Swiss franc as
funding currencies, pointing out that carry trade is pursued
when the interest differential is wide enough to compensate
traders for the underlying foreign exchange risk.
2
They nd
evidence supporting the view that downside risk is an
important feature of carry trade and that using measures
of downside risk (as opposed to the standard deviation)
reduces the Sharpe ratio, though it remains higher than
those obtainable from share markets. Like Gyntelberg and
Remolona (2007), Hottori and Shin (2007) nd evidence
indicating that volumes of carry trade involving the yen are
high when interest differentials against the yen are high.
3
Moosa used currency combinations involving two
funding currencies and three target currencies to analyse
the protability of carry trade over the period 19962006.
4

The results show that carry trade can be protable over a
long period of time but it is also highly risky because an
adverse movement in the underlying exchange rate could
wipe out the carry trader once and for all. Although it may
appear that carry trade produces higher Sharpe ratios than
those associated with share market investment, several
reasons are presented for why carry trade is not as lucrative
as it may appear.
R
E
S
E
A
R
C
H
THE PROFITABILITY OF CARRY TRADE
1
C. Burnside, M. Eichenbaum, I. Kleshcelski and S. Rebelo, The Returns to Currency Speculation, NBER Working Papers, No 12489,
2006.
2
J. Gyntelberg and E. M. Remolona, Risk in Carry Trades: A Look at Target Currencies in Asia and the Pacic, BIS Quarterly Review,
December, 2007, pp. 7382.
3
M. Hottori and H. S. Shin, The Broad Yen Carry Trade, Bank of Japan, Institute for Monetary and Economic Studies, Discussion Paper
No. 2007-E-19, 2007.
4
I. A. Moosa, Risk and Return in Carry Trade, Journal of Financial Transformation, 22, 2008, pp. 813.
EXAMPLE
11.9
The one-year interest rates on the Australian dollar and the US dollar are 4 and 7 per cent
respectively. The current exchange rate (AUD/USD) is 1.80. An investor is considering uncovered
arbitrage by taking a short position on (borrowing) the Australian dollar and a long position
on (lending) the US dollar. Since the interest rate differential is 3 per cent, this investor will
make profit (ignoring transaction costs) as long as the US dollar does not depreciate against the
Australian dollar by more than 3 per cent. The following table shows the rate of return (uncov-
ered margin) for various levels of the exchange rate prevailing on the maturity of the investment
for arbitrage in both directions.
S0 S1 AUD USD USD AUD
1.80 1.85 5.8 5.8
1.80 1.80 3.0 3.0
1.80 1.75 0.2 0.2
1.80 1.70 2.6 2.6
1.80 1.65 5.3 5.3
Suppose now that the Australian dollar interest rate rose to 9 per cent while the US dollar
interest rate remained unchanged. The investor will be willing to do the same only if he or
she expects the US dollar to appreciate by more than 2 per cent. The following table shows the
uncovered margin for various levels of the nal exchange rate:
S0 S1 AUD USD USD AUD
1.80 1.95 0.8 0.7
1.80 1.90 2.0 2.0
1.80 1.85 4.8 4.8
1.80 1.80 7.5 7.6
1.80 1.75 10.3 10.3
p =
S
0
}
S
1
(1 + i) (1 + i
*
) 11.30
or approximately
p = i i
*
S

11.31
Equation (11.31) tells us that the uncovered margin on arbitrage from the foreign to the domestic
currency consists of the interest rate differential (measured the other way round) and the nega-
tive of the percentage change in the exchange rate.
Uncovered arbitrage with bidoffer spreads
Let us now reconsider uncovered arbitrage by allowing for bidoffer spreads in both exchange
and interest rates, as illustrated in Figure 11.11. Remember that a price-taker in the foreign
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338 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 339 338 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
exchange market buys at the (higher) offer exchange rate and sells at the (lower) bid exchange
rate of the market-maker. A price-taker in the money market borrows at the (higher) offer inter-
est rate and lends at the (lower) bid interest rate of the market-maker.
Arbitrage from the domestic currency to a foreign currency consists of the following steps:
The arbitrager borrows domestic currency funds at the domestic offer interest rate, i
a
.
Borrowed funds are converted into the foreign currency at the spot offer rate, S
a0
, obtaining
1/S
a0
foreign currency units. This amount is invested at the foreign bid interest rate, i
b

*
.
The foreign currency value of the invested amount at the end of the investment period is
(1/S
a0
)(1 + i
b

*
).
FIGURE 11.11 Uncovered interest arbitrage with bidoffer spreads
Borrowing
domestic
currency
Converting at
spot offer rate
Investing at
foreign bid rate
1 unit
1
Sa0
Loan
repayment
Loan
repayment
Borrowing
foreign
currency
Converting at
spot bid rate
Reconverting at
spot bid rate
Reconverting at
spot offer rate
Investing at
domestic bid rate
Uncovered margin Uncovered margin
Domestic Foreign Foreign Domestic
Sb1
Sa0
Sb0
1 unit
(1 + i*) b
a
Sb1
Sa0
(1 + i*) (1 + i ) b
1 + ia
1
Sa0
(1 + i*) b
1 + i*
a
Sb0
Sa1
(1 + i ) b
Sb0(1 + i ) b
Sb0
Sa1
(1 + i ) (1 + i*) b a
This amount is reconverted into the domestic currency at the bid spot rate, S
b1
, to obtain
(S
b1
/S
a0
)(1 + i
b

*
) domestic currency units.
The value of the loan plus interest per unit of the domestic currency is (1 + i
a
).
The uncovered margin in this case is
p =
S
b1
}
S
a0
(1 + i
b

*
) (1 + i
a
) 11.32
Since S
b1
/S
a0
= (1 + S

b
)/(1 + m), it follows that
p = i
b

*
i
a
+ S

b
m 11.33
where S
.
b
is the percentage change in the bid exchange rate. It can be seen from equations (11.32)
and (11.33) that the uncovered margin is lower if we allow for the bidoffer spreads.
Arbitrage from a foreign currency to the domestic currency consists of the following steps:
The arbitrager borrows foreign currency funds at the foreign offer interest rate, i
a

*
.
Borrowed funds are converted into the domestic currency at the spot bid rate, S
b0
, obtaining
S
b0
domestic currency units. This amount is invested at the domestic bid interest rate, i
b
.
The domestic currency value of the invested amount at the end of the investment period is
S
b0
(1 + i
b
).
This amount is reconverted into the foreign currency at the offer spot rate, S
a1
, to obtain
(S
b0
/S
a1
)(1 + i
b
) foreign currency units.
The value of the loan plus interest is (1 + i
a

*
) foreign currency units.
U
ncovered arbitrage is a risky operation, because an
adverse change in the exchange rate could wipe out
the gains derived from the interest rate differential. Thus,
what prevents an arbitrager from going short on a low
interest currency and long on a high interest currency is
the fear that the high interest currency would depreciate
against the low interest currency. We have seen that
one way of eliminating this risk is by covering the long
position in the forward market. In practice, this (covered
arbitrage) operation would not produce much prot, since
covered interest parity tends to hold.
Is there any other way of eliminating or reducing
foreign exchange risk in uncovered arbitrage that
makes it possible to utilise the interest rate differential
without being concerned about adverse movements
in the exchange rate? The answer is surprisingly yes.
This could be done in two cases. The rst involves two
currencies whose exchange rates against the US dollar are
highly correlated. If this is so, the cross exchange rate
between the two currencies tends to be stable, reducing
foreign exchange risk to a minimal level. The second
case involves a currency that is pegged to a basket. If
the currency components of the basket can be revealed
(which would take some research), arbitrage prot can be
made by taking short (long) positions on the component
currencies and a corresponding long (short) position on
the pegged currency. If the structure of the portfolio
of the component currencies is similar to the structure
of the basket (that is, if the weights are equal), it would
be as if the arbitrager is taking a long (short) position
on a currency and a short (long) position on the same
currency. This is because the exchange rate of the pegged
currency against the dollar is a weighted average of the
exchange rates of the component currencies against the
dollar. A more detailed description of these operations is
available.
1
I
N

P
R
A
C
T
I
C
E
INNOVATIVE UNCOVERED ARBITRAGE
1
I. A. Moosa, International Financial Operations: Arbitrage, Hedging, Speculation, Financing and Investing, Palgrave, London, 2003.
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340 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH CHAPTER 11 I NTERNATI ONAL ARBI TRAGE 341 340 I NTERNATI ONAL FI NANCE: AN ANALYTI CAL APPROACH
Uncovered arbitrage is triggered by the violation of the uncovered interest parity (UIP)
condition. It is described as uncovered because, unlike covered arbitrage, the long currency
position is not covered in the forward market but rather left uncovered or open.
Arbitrage is less profitable when we allow for bidoffer spreads, because these spreads
represent transaction costs.
The uncovered margin in this case is
p =
S
b0
}
S
a1
(1 + i
b
) (1 + i
*
a
) 11.34
Since S
b0
/S
a1
= 1/[(1 + S
.
b
)(1 + m)], it follows that
p = i
b
i
*
a
S
.
b
m 11.35
EXAMPLE
11.10
Consider the previous example with bidoffer spreads. The exchange rates are as shown in the
table, whereas the interest rates are 3.754.25 and 6.757.25. The uncovered margin should
now be as in the table.
S0 S1 AUD USD USD AUD
1.79501.8050 1.94501.9550 10.8 12.0
1.79501.8050 1.89501.9050 7.8 9.5
1.79501.8050 1.84501.8550 4.9 6.9
1.79501.8050 1.79501.8050 1.9 4.1
1.79501.8050 1.74501.7550 1.1 1.1
SUMMARY
Arbitrage is generally defined as capitalising on a discrepancy in quoted prices as a result of
the violation of an equilibrium (no-arbitrage) condition.
Two-point arbitrage arises when the exchange rate between two currencies assumes two
different values in two financial centres at the same time.
Three-point arbitrage is triggered by the violation of a no-arbitrage condition, which is the
consistency of the cross rates.
Two steps are involved in three-point arbitrage: (i) checking whether or not the condition
is violated (that is, whether or not the cross rates are consistent); and (ii) determining the
profitable sequence.
Multi-point arbitrage involves four, five or more currencies. Three-point arbitrage is sufficient
to establish consistent exchange rates, eliminating the profitability of multi-point arbitrage.
The no-arbitrage condition in the case of commodity arbitrage is the law of one price (LOP),
which stipulates that, in the absence of frictions such as shipping costs and tariffs, the price
of a commodity expressed in a common currency is the same in every country.
Covered interest arbitrage is triggered by the violation of the covered interest parity (CIP)
condition, which describes the equilibrium relation between the spot exchange rate, the
forward exchange rate, domestic interest rates and foreign interest rates.
arbitrage 313
carry trade 332
commodity arbitrage 321
covered interest arbitrage 323
covered interest parity 323
covered margin 325
deannualisation 329
interest parity forward rate 327
law of one price (LOP) 321
locational arbitrage 314
multi-point arbitrage 319
net arbitrage profit 325
no-arbitrage condition 313
risk-neutral 325
spatial arbitrage 314
three-point arbitrage 316
triangular arbitrage 316
two-point arbitrage 314
uncovered arbitrage 331
uncovered interest parity 331
uncovered margin 335
1. What are the no-arbitrage conditions for (i) two-point arbitrage, (ii) three-point arbitrage, and (iii) four-point
arbitrage?
2. Explain how the equilibrium condition implied by the LOP is maintained and restored when it is violated.
3. What are the practical business implications of CIP?
4. Why is risk neutrality an important assumption for deriving the CIP condition?
5. Why is covered interest arbitrage covered?
6. What is the interest parity forward rate?
7. In equilibrium, the currency offering a lower interest rate must sell at a forward premium, while the currency offering
a higher interest rate must sell at a forward discount. Why?
8. Explain how covered arbitrage restores the CIP equilibrium condition when it is violated.
9. What is the covered margin?
10. What is the effect of the presence of bidoffer spreads in interest and exchange rates on the CIP equilibrium
condition and on the profitability of covered interest arbitrage?
11. Why is uncovered interest arbitrage uncovered?
12. What is the connection between CIP and UIP?
13. The difference between the specification of CIP and UIP reflects the difference between covered and uncovered
arbitrage. Explain.
14. Uncovered interest parity tells us that a currency that offers a higher interest rate is expected to depreciate. Is it
possible to reconcile this proposition with the prediction of the supply and demand model pertaining to the effect of
interest rate on the exchange rate?
KEY TERMS
REVIEW QUESTIONS
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6. You are given the following information:
Spot exchange rate (AUD/EUR) 1.60
One-year forward rate (AUD/EUR) 1.62
One-year interest rate on the Australian dollar 8.5%
One-year interest rate on the euro 6.5%
(a) Is there any violation of CIP?
(b) Calculate the covered margin (going short on the AUD).
(c) Calculate the interest parity forward rate and compare it with the actual forward rate.
(d) Calculate the forward spread and compare it with the interest differential.
(e) What would arbitragers do?
(f) If arbitrage is initiated, suggest some values for the interest and exchange rates after it has stopped and
equilibrium has been reached.
7. You are given the following information:
Spot exchange rate (AUD/CHF) 1.1500
Three-month forward rate (AUD/CHF) 1.1585
Australian three-month interest rate 10.5% p.a.
Swiss three-month interest rate 6.5% p.a.
(a) Is there any violation of CIP?
(b) Calculate the covered margin (going short on the AUD).
(c) Calculate the interest parity forward rate and compare it with the actual forward rate.
(d) Calculate the forward spread and compare it with the interest differential.
(e) What would arbitragers do?
8. You are given the following information:
Spot exchange rate (CAD/GBP) 2.42
Six-month forward rate (CAD/GBP) 2.46
Canadian six-month interest rate 8% p.a.
UK six-month interest rate 10% p.a.
(a) Is there any violation of CIP?
(b) Calculate the covered margin from a Canadian perspective (going short on the CAD).
(c) Calculate the interest parity forward rate in direct quotation from a Canadian perspective and compare it with the
actual forward rate.
(d) Calculate the forward spread and compare it with the interest differential from a Canadian perspective.
(e) What would arbitragers do?
(f) Redo all the calculations from a UK perspective (going short on the GBP).
9. You are given the following information:
Spot exchange rate (AUD/EUR) 1.59501.6050
One-year forward rate (AUD/EUR) 1.61501.6250
One-year interest rate on the Australian dollar 8.258.75
One-year interest rate on the euro 6.256.75
(a) Calculate the covered margin (going short on the AUD).
(b) What would arbitragers do?
(c) Compare the results with those obtained by solving Problem 6.
1. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.56
London (GBP/AUD) 0.35
(a) Is there a possibility for two-point arbitrage?
(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?
2. The following exchange rates are quoted simultaneously in Sydney, Frankfurt and Zurich:
AUD/EUR 1.6400
CHF/AUD 0.8700
CHF/EUR 1.4600
(a) Is there a possibility for two-point arbitrage?
(b) Is there a possibility for three-point arbitrage?
(c) If so, what is the profitable sequence?
(d) What is the profit earned from arbitrage?
(e) How do the three exchange rates change as a result of arbitrage?
(f) What is the value of the CHF/EUR exchange rate that eliminates the possibility for profitable arbitrage?
3. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.55752.5625
London (GBP/AUD) 0.34750.3525
(a) Is there a possibility for two-point arbitrage?
(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?
(d) Compare the results with those obtained from Problem 1 above.
4. The following exchange rates are quoted:
JPY/AUD 67.16
GBP/AUD 0.3484
CHF/AUD 0.8012
CAD/AUD 0.8711
(a) Calculate all possible cross rates.
(b) Using the calculated cross rates, show that there is no opportunity for three-point, four-point or five-point
arbitrage.
(c) If the cross rates were 10 per cent higher than those obtained in (a) above, show that there are opportunities for
profitable three-point, four-point or five-point arbitrage.
5. The price of a commodity in New Zealand is NZD10, while the price of the same commodity in Australia is AUD6. The
current exchange rate (NZD/AUD) is 1.15.
(a) Is there a violation of the LOP?
(b) If so, what will happen?
(c) What is the Australian dollar price compatible with the LOP at the current exchange rate?
(d) At the current Australian dollar price, what is the exchange rate compatible with the LOP?
PROBLEMS
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13. You are given the following information:
Spot exchange rate (USD/GBP) 1.46
Spot exchange rate (USD/CAD) 0.64
US one-year interest rate 6%
UK one-year interest rate 8%
Canadian one-year interest rate 10%
(a) Calculate the one-year forward rate between the Canadian dollar and the UK pound (CAD/
GBP) by adjusting the spot rate for the interest rate differential.
(b) Calculate the same forward rate as a cross rate. Do you obtain the same answer? Why or
why not?
14. The current AUD/EUR exchange rate is 1.60, the Australian three-month interest rate is 8.5
per cent p.a. and the three-month interest rate on the euro is 6.5 per cent p.a. Where will the
exchange rate be in three months time if UIP holds?
15. Reconsider Problem 14 by assuming that the exchange rate in three months time turned out
to be 1.68. Calculate the uncovered margins obtained by going short on the Australian dollar
and long on the euro, and vice versa.
16. The following information is available:
Spot exchange rate (CAD/GBP) 2.32
Canadian six-month interest rate 8% p.a.
UK six-month interest rate 10% p.a.
Calculate the uncovered margin obtained by going short on the Canadian dollar if the
exchange rate assumes the following values in six months: (a) 2.25, (b) 2.28, (c) 2.32,
(d) 2.35 and (e) 2.38. Do the same by going short on the pound.
17. The following information is available:
Spot exchange rate (CAD/GBP) 2.31502.3250
Canadian six-month interest rate 7.758.25 p.a.
UK six-month interest rate 9.7510.25 p.a.
Calculate the uncovered margin by going short on the Canadian dollar if the exchange rate
assumes the following values in six months: (a) 2.24752.2525, (b) 2.27752.2825, (c)
2.31752.3225, (d) 2.34752.3525 and (e) 2.37752.3825. Do the same by going short on
the pound.
10. You are given the following information:
Spot exchange rate (AUD/CHF) 1.14501.1550
Three-month forward rate (AUD/CHF) 1.15351.1635
Australian three-month interest rate 10.2510.75 p.a.
Swiss three-month interest rate 6.256.75 p.a.
(a) Calculate the covered margin (going short on the AUD).
(b) What would arbitragers do?
(c) Compare the results with those obtained by solving Problem 7.
11. You are given the following information:
Spot exchange rate (CAD/GBP) 2.41502.4250
Six-month forward rate (CAD/GBP) 2.45502.4650
Canadian six-month interest rate 7.758.25 p.a.
UK six-month interest rate 9.7510.25 p.a.
(a) Calculate the covered margin from a Canadian perspective (going short on the CAD).
(b) Calculate the covered margin from a UK perspective (going short on the GBP).
(c) What would arbitragers do?
(d) Compare the results with those obtained by solving Problem 8.
12. The table below shows a set of data consisting of 15 observations on the spot and three-month forward rates
between the Australian dollar and the Canadian dollar, as well as the Australian and Canadian three-month interest
rates. On the basis of this data set, you are required to do the following (all calculations are to be carried out from
an Australian perspective):
(a) Calculate the interest parity forward rate and plot it against the actual forward rate.
(b) Calculate the percentage deviation of the actual forward rate from the interest parity forward rate and plot it.
(c) Calculate the covered margin and plot it.
OBSERVATION SPOT
AUD/CAD
FORWARD
AUD/CAD
AUSTRALIAN
INTEREST
CANADIAN
INTEREST
1 1.0643 1.0692 4.84 4.59
2 1.1000 1.1037 4.93 4.87
3 1.1003 1.0904 4.85 4.91
4 1.0672 1.0520 4.62 4.66
5 1.0449 1.0440 4.66 4.63
6 1.0170 1.0188 4.70 4.56
7 1.0447 1.0398 4.78 4.66
8 1.0555 1.0538 5.08 4.85
9 1.1365 1.1339 5.78 5.27
10 1.1325 1.1295 5.87 5.53
11 1.2259 1.2163 6.41 5.56
12 1.1942 1.1969 6.03 5.49
13 1.3066 1.3165 4.98 4.58
14 1.2918 1.2941 4.88 4.30
15 1.2890 1.2838 4.30 3.05
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