BAFI1018 International Finance

Topic 5: Arbitrage and CIP

Chapter 11
 Objectives

• 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

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
 Objectives

• To explain the concept of market efficiency

• To describe the Uncovered Interest Parity (UIP)
condition and explain the effect of uncovered
arbitrage
• To explain the concept of the real interest rate
• To derive the Real Interest Parity (RIP) condition

(cont.)
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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa 11-3
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 Commodity arbitrage

• Recall LOP, in the absence of frictions, the price of a

commodity i, must be the same in every country,
linked by the exchange rate, S.

*
Pi  SP i

• In the case of commodity arbitrage, this is known as

the no-arbitrage condition
(cont.)
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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Commodity arbitrage

(cont.)
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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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 Definition of arbitrage

• 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

(cont.)
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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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 Two-point arbitrage

• Also known as spatial or locational arbitrage, it

arises when the following condition is violated:

S A ( x / y)  SB ( x / y)

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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The effect of two-point arbitrage
S(x/y) S(x/y)
Sy Sy

(S A )0
( S A )1 ( S B )1
(S B )0

Dy Dy
Qy Qy
A B
Two-Point Arbitrage: Example
• Suppose that
 Sydney – 3.5780 (AUD/GBP)
 London – 0.5120 (GBP/AUD)
 Invert the exchange rate in London, which gives
(AUD/GBP) = 1/0.5120 = AUD1.9531
 The equilibrium condition is violated because the GBP is
more expensive in Sydney than in London
 Arbitragers buy the GBP in London at 1.9531 and sell it in
Sydney at 3.5780, making a profit of
π=3.5780-1.9531=1.6249
 The effect of arbitrage is to raise the price of the GBP in
London and to lower it in Sydney, until they are equalised
somewhere between 1.9531 and 3.5780
 Two-point arbitrage with bid-offer spreads

• With bid-offer spreads the no-arbitrage condition

becomes:

Sb , A  x / y   S a , B  x / y 

S a , A  x / y   Sb , B  x / y 

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Two-Point Arbitrage: Example
• Suppose for GBP/AUD
 Sydney: 0.3750 – 0.3790
 London: 0.3700 – 0.3740
 The equilibrium condition is violated
 Arbitragers buy the AUD in London at 0.3740 and sell it in
Sydney at 0.3750, making a profit of
π=0.3750-0.3740=0.0010 GBP or 10 points
• The effect of arbitrage is to raise the price of the AUD in London
and to lower it in Sydney, until they are equalised somewhere
between 0.3740 and 0.3750
OR
•Arbitragers buy the GBP in Sydney at 2.6667 (1/0.3750) and
sell it in London at 2.6738 (1/0.3740), making a profit of
π=2.6738-2.6667=0.00713 AUD or 71.3 points
 Three-point (triangular) arbitrage
• It is triggered when cross exchange rates are
inconsistent, that is, when the following condition is
violated:

S ( x / z)
S ( x / y) 
S ( y / z)
or

S ( x / y ) S ( y / z ) S ( z / x)  1

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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Three-Point Arbitrage (cont’d)

• No-arbitrage condition if S ( x / y ) 
S ( x / z)
S ( y / z)
S ( x / z)
• If S ( x / y )  ,
S ( y / z)
possibility of arbitrage profit arises by following the sequence
x → z → y → x.
S ( x / z)
• If S ( x / y )  ,
S ( y / z)
possibility of arbitrage profit arises by following the sequence
x → y → z → x.
Profitable/unprofitable sequences
(a) Unprofitable sequence (b) Profitable sequence

x x

S ( x / z)
S ( x / y) 
S ( y / z)

z y z y
S ( x / z) S ( x / y)S ( y / z )
1 1
S ( x / y)S ( y / z ) S ( x / z)

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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Three-Point Arbitrage: Example
• Suppose that the following exchange rates are
given:
S(CAD/AUD) = 3.5619
S(NZD/AUD) = 1.2052
S(CAD/NZD) = 2.5825
The cross rate is given by

S (CAD / AUD) 3.5619

SCR (CAD / NZD)    2.9554
S ( NZD / AUD) 1.2052
Since the equilibrium condition is violated, because the
actual S(CAD/NZD)≠SCR(CAD/NZD), there is a possibility
to engage in three-point arbitrage
 Three-Point Arbitrage: The Unprofitable Sequence

(a) Unprofitable sequence •Start with one currency and move

CAD clockwise
•Sell 1 unit of CAD and obtain
0.2807 units of AUD
•Sell 0.2807 units of AUD and
S(CAD/NZD) S(CAD/AUD)
=3.5619 obtain 0.3384 units of NZD
=2.5825
•Sell 0.3384 units of NZD and
obtain 0.8738 units of CAD.
•It is not profitable because you
end up with less units of CAD than
NZD AUD what you start with
S(NZD/AUD) = 1.2052
Three-Point Arbitrage: The Profitable Sequence
(b) Profitable sequence

•Start with one currency and move CAD

clockwise
•Sell 1 unit of CAD and obtain
0.3872 units of NZD
•Sell 0.3872 units of NZD and S(CAD/NZD) S(CAD/AUD)
=2.5825 =3.5619
obtain 0.3213 units of AUD
•Sell 0.3213 units of AUD and
obtain 1.1444 units of CAD.
•It is profitable because you end up
with more units of CAD than what
you start with NZD AUD
S(NZD/AUD) = 1.2052
 Multipoint arbitrage

• Arbitrage involving 4, 5, 6 or more currencies can

take place
• The condition precluding multipoint arbitrage is:

S ( x1 / x2 ) S ( x2 / x3 ) S ( xn / x1 ) 1

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The CIP Equilibrium Condition
• The yield on a domestic asset
= the yield on a foreign asset
(covered against exchange rate risk)
The wealth earned from $1 invested in the domestic
market for one period is
$1(1+i)
$1(1  i )

The wealth earned from $1 invested in the foreign

market for one period is
F
$1 (1  i * )
S
Return on Investments
Investor
(K)

Foreign Domestic
investment investment

Converting at
spot rate
K
S

Investing in
foreign assets

K
(1  i )
S
Reconverting at
forward rate

KF K (1  i )
(1  i )
S

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
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 The CIP Equilibrium Condition
• Both investments should yield the same return
Equate the two together Yield from foreign
investment
F
Yield from domestic (1  i )  (1  i * )
investment S
This states that the gross domestic return on an
investment is equal to the gross covered foreign return
The CIP Equilibrium Condition
• The approximate CIP condition can be expressed as

i  i*  f
and
F S
 i  i*
S
Implications of the CIP Condition
• The currency offering the higher rate of interest must sell at a forward
discount
 If i > i*, then f > 0
 The foreign currency, which is offering a lower interest rate, must sell
at a forward premium
– The foreign currency becomes more expensive to buy
 The domestic currency, which is offering a higher interest rate, must
sell at a forward discount
– The domestic currency becomes cheaper to buy
 If i < i*, then f < 0
 The foreign currency, which is offering a higher interest rate, must sell
at a forward discount
– The foreign currency becomes cheaper to buy
 The domestic currency, which is offering a lower interest rate, must
sell at a forward premium
– The domestic currency becomes more expensive to buy
 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 forward
exchange rate, domestic interest rates and foreign
interest rates

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Covered Interest Arbitrage
• An investor borrows in one currency and invests in
another while covering the exchange rate risk using
a forward contract
• It arises because of a positive difference between
the proceeds from an investment, and the loan
repayment
The covered margin, π, is positive
Covered interest arbitrage
Domestic  foreign Foreign  domestic

Borrowing Borrowing
domestic currency foreign currency
1 unit 1 unit

Converting at Converting at
spot rate spot rate
1
S
S
Investing at Loan Loan Investing at
foreign rate repayment repayment domestic rate
1
(1  i ) S (1  i )
S
Reconverting at Reconverting
forward rate at forward rate
F S
(1  i ) 1 i 1  i (1  i )
S F
Covered margin Covered margin

F S
(1  i )  (1  i ) (1  i )  (1  i )
S F

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa
Slides prepared by Afaf Moosa
Covered Interest Arbitrage
• In an arbitrage from the domestic currency to a
foreign currency
The covered margin, π, is the difference between
the domestic currency value of the proceeds and
the loan repayment
F
  (1  i * )  (1  i )
S
or approximately

  i*  i  f
Covered Interest Arbitrage
• In an arbitrage from a foreign currency to the
domestic currency
The covered margin is the difference between the
foreign currency value of the proceeds and the loan
repayment
S
 (1  i )  (1  i * )
F
or approximately

  i  i*  f
Covered Interest Arbitrage
New York
One year Today

Finish: Start:

7. Net profit equals $5,200. 1. Borrow $1 million at an interest rate of 7% (owing

$1,070,000 at year end).

6. Repay$1,070,000 (the loan plus 2. Convert the $1 million to pounds at $1.75/£ for
interest) of out of the $1,075,200. £571,428.57

5. Collect the £640,000 and deliver 3. Invest the £571,428.57 in London at 12%,
it to the bank’s foreign exchange (receiving £640,000 by year end)
department in return for
$1,075,200.

London: one year London: today

4. Simultaneously, sell the £640,000 in
principal plus interest forward at a rate of
$1.68/£ for delivery in one year (yielding
$1,075,200 at year end)

Source: Sharpiro (2006), Multinational Financial Management

The CIP Forward Rate
• The no-arbitrage condition is obtained when the
covered margin,π, is equal to zero

F 
which gives (1  i )  (1  i )
S

 1 i 
F  S *
1  i 
The CIP Forward Rate
• Here, F is the implied interest parity forward rate,
which is the value of the forward rate consistent
with no arbitrage opportunities
If CIP holds, then F  F meaning that the
interest parity forward rate is equal to the actual
forward rate
The CIP Condition – An Example
• Suppose that
The current spot rate is S(AUD/GBP) = 3.8000
The 3-month forward rate is F(AUD/GBP) = 3.7800
The 3-month (annualised) interest rate in Australia is
7%
The 3-month (annualised) interest rate in the UK is
5.50%
The CIP Condition – An Example
• We must convert the annual interest rates into
quarterly interest rates

i  0.07 12 3  0.0175

i*  0.055 12 3  0.01375

The CIP Condition – An Example
• We then use our CIP condition
F(AUD / GBP) - S(AUD / GBP)
f= f = i - i*
S ( AUD / GBP )

3.7800 - 3.8000 = 0.0175 - 0.01375

=
3.8000 = 0.00375
= -0.00526
= 0.375%
= -0.526%
F -S
¹ i -i *

S
The CIP Condition – An Example
• Qualitatively, there is a violation in the CIP
condition, because the British pound, which is
offering a lower rate of return, is selling at a forward
discount
The currency offering a lower rate of return must sell
at a premium, for equilibrium to hold
• Quantitatively, the interest rate differential is greater
than the forward spread (discount)
Funds would flow from the UK to Australia
This will eventually lead to changes in interest rates
and exchange rates in both countries
Covered arbitrage with bid-offer spreads
• Arbitrager is a price taker and the banker is a market
maker in the foreign exchange market, therefore an
arbitrager
Buys at the (higher) offer exchange rate
Sells at the (lower) bid exchange rate
• As price taker in the money market
borrows at the (higher) offer interest rate
lends at the (lower) bid interest rate
 Covered arbitrage with bid-offer spreads
• Arbitrager borrows domestic (foreign) currency funds at
the domestic (foreign) offer interest rate, ia (ia* )
• Convert borrowed funds into foreign (domestic) currency
at the spot offer (bid) rate, Sa (Sb), obtaining 1/Sa (Sb)
foreign (domestic) currency units. This amount is invested
at the foreign (domestic) bid interest rate, i * (ib)
b
• The foreign (domestic) currency value of the invested
amount at the end of the investment period is (1 / S a )(1  ib* )
(Sb(1+ib))
• Reconvert this amount into domestic (foreign) currency
( Fb / S a )(1  ib* )
at the forward bid (offer) rate, Fb (Fa), to obtain
domestic ((Sb/Fa)(1+ib), foreign) currency units
• The value of the loan plus interest is (1+ia) domestic
(foreign, (1  ia ) ). currency units
*
Covered interest arbitrage in the presence of bid-
offer spreads
Domestic  foreign Foreign  domestic

Borrowing domestic currency Borrowing foreign currency

1 unit 1 unit

Converting at spot rate Converting at spot rate

1 Sb
Sa
Loan Loan
Investing at foreign rate repayment Investing at domestic rate
repayment
1
Sa
(1  ib* ) Sb (1  ib )
Reconverting at forward rate Reconverting at forward rate
Fb Sb
Sa
(1  ib* ) 1  ia 1  ia* Fa
(1  ib )

Covered margin Covered margin

Fb Sb
(1  ib* )  (1  ia ) (1  ib )  (1  ia* )
Sa Fa
Covered arbitrage with bid-offer spreads
• In an arbitrage from the domestic currency to a
foreign currency, the covered margin is calculated as
Fb
  (1  ib* )  (1  ia )
Sa
Since Fb/Sa=(1+f)/(1+m), where f is the forward
spread and m is the bid-offer spread, it follows that

  ib*  ia  f  m

  i  i*  f
Covered arbitrage with bid-offer spreads
• In an arbitrage from the foreign currency to a
domestic currency, the covered margin is calculated
as
Sb
  (1  ib )  (1  ia* )
Fa

Since Sb/Fa=1/[(1+m)(1+f)], it follows that

  ib  ia*  f  m
Covered arbitrage and the consistency of cross
forward rates
• Through covered arbitrage in the spot market, it is
possible to maintain the consistency of cross forward
rates, meaning the cross forward rate between 2
currencies is identical to the forward rate that is
actually quoted in the market.
This can be calculated as
 1  ix 
S ( x / z ) 
F ( x / y)   1  iz   F ( x / z)
 1  i y  F ( y / z)
S ( y / z ) 
 1  iz 
Reasons for interest in CIP
• The reasons for the increased interest in CIP are
It can be used as a measure of capital mobility
It links the term structure of interest rates with the
term structure of forward spreads
 f = (F – S)/S ≈ i – i*
It implies optimal resource allocation in a market
economy
It has implications for financing and investment
decisions
Deviations from CIP
• Deviations from CIP are indicated by a non-zero
covered margin
CIP has been found to hold precisely in the integrated
and unregulated Eurocurrency market
This is not surprising, because these markets come
close to satisfying the notion of a perfectly competitive
financial market
 Very low transaction costs
 Minimal taxes
 Very little capital controls
Measurement errors tend to give rise to non-zero
covered margins
Deviations from CIP
• There are a number of factors that make covered
arbitrage opportunities unprofitable or unattractive
Transaction costs
Political risk
Tax differentials
Liquidity differences
Other factors, such as capital controls
The PPP and CIP

Purchasing power parity


1 Ih 
1  I If
1  I 
%  in spot exchange rate, ef Sf h
Inflation rate differential, Ih – If f

Interest rate parity


1  ih 
1  i if
1  i 
Forward rate premium p f h
Interest rate differential ih – if f
Introduction
• In this topic, we look at three related concepts
 Market efficiency
 Prices reflect all available information such that it is not
possible to make abnormal profits
 Uncovered interest parity
 A condition obtained through uncovered interest
arbitrage, in which the long position is not covered in the
forward market
 Real interest parity
 Implies the integration of both goods and financial
markets
The Concept of Market Efficiency
• The foreign exchange market is said to be
‘informationally efficient’ if prices reflect all
available information
 It is not possible to predict price movements from the
available information because this is already reflected
in current prices
 The arrival of information is random, and since this
new information is reflected in prices quickly, the
changes in prices tend to be random
 It is not possible to earn abnormal returns through
active trading
 The same amount of profit can just as easily be obtained
from a passive buy-and-hold strategy
Foreign Exchange Market Efficiency
• There are three degrees of efficiency
 Weak-form efficiency
 Historical information
 Semi-strong form efficiency
 Historical and public information,
 Strong-form efficiency
 Historical, public and private information
Spot and Forward Market Efficiency
• The efficiency of the spot foreign exchange market
implies that the spot exchange rate moves in a
random, unpredictable manner, reflecting the
random arrival of new information

S t  S t 1  ε t
 It is not possible to make a profit by speculating in
the foreign exchange market
 The exchange rate follows a random walk
 It has no systematic pattern, and hence, is
unpredictable
Spot and Forward Market Efficiency
• The concept of forward market efficiency
encompasses both the spot and forward markets

 The forward market is said to be efficient if it reflects

all available information, where the information is
embodied in the forward rate

 The forward rate performs this function because it

represents the collective wisdom of many well-
informed profit-seeking traders, and also because it
is revised quickly as new information becomes
available
Spot and Forward Market Efficiency
• Forward market efficiency requires that
S F
e

or

S  F  ζt
e

 The difference between the forward and spot rate is

the forecasting error, ζt
 This implies that the forward rate is an efficient and
unbiased forecaster of the spot exchange rate:
 Unbiased efficiency: It is not possible to improve
forecast by using information other than what is
embodied in the forward rate.
 Uncovered interest arbitrage

• 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

 Carry trade

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PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa 11-52
Slides prepared by Afaf Moosa
Use of the Forward Rate
• Since F = S(1+p)
where p = forward premium / the percentage by
which the forward rate exceeds the
spot rate
• Hence, p is the expected percentage change in the
exchange rate
E(e)=p
=(F/S)-1
Example 3
360-day F(USD/AUD) 0.63

S(USD/AUD) 0.60

E(e) = p
= (F/S) – 1
= (0.63/0.60) – 1
= 0.05 or 5%

The 1-year spot rate is expected to rise by 5%

Uncovered Interest Parity (cont’d)
• The UIP relationship is important for a number of
reasons
It indicates the degree of financial market integration
It indicates the degree of interest rate linkages across
countries
Is a component of many exchange rate determination
models
It also has important implications for the investment
and financing decisions of firms
The UIP Equilibrium Condition
• The yield on a domestic asset
= the yield on a foreign asset
(uncovered against exchange rate risk)
The wealth earned from $1 invested in the domestic
interest earning asset for one period is $1(1+i)
The wealth earned from $1 invested in the foreign
denominated interest earning asset for one period is
Contrast this with CIP:
Se F
$1 (1  i  ) $1 (1  i * )
S S
The UIP Equilibrium Condition (cont’d)
• Both investments should yield the same return
Equate the two together

Se
1 i  (1  i )
*

S
This states that the gross domestic return on an
investment is equal to the gross uncovered foreign
return
The UIP Equilibrium Condition (cont’d)

• The approximate UIP condition can be expressed as

* 
i i  S e
Implications of the UIP Condition
• The currency offering the higher rate of interest must
be expected to depreciate
 If i > i*, then S  0
e

 The foreign currency, which is offering a lower interest

rate, is expected to appreciate
 The domestic currency, which is offering a higher
interest rate, is expected to depreciate
If i < i*, then S e  0
 The foreign currency, which is offering a higher interest
rate, is expected to depreciate
 The domestic currency, which is offering a lower interest
rate, is expected to appreciate
The UIP Condition – An Example
• Suppose that
S(AUD/USD) = 1.8000
The 3-month (annualised) interest rate in Australia is
6%
The 3-month (annualised) interest rate in the US is 4%
The UIP Condition – An Example
• If UIP holds then

6 4
i  i    0.5%
*

4 4
Three months from now, the US dollar should
appreciate 0.5%
The level of the exchange rate 3 months from now
should be 1.005 x 1.80 = 1.8090
Return on Investments
(with Uncovered Position)
Investor
(K)

Foreign Domestic
Investment Investment

Converting at
spot rate
K
S
Investing in
foreign assets

K
(1  i )
S
Reconverting at
expected spot
rate
KS e K (1  i )
(1  i )
S
Uncovered Interest Parity
Domestic  foreign Foreign  domestic

Borrowing domestic Borrowing foreign

currency currency
1 unit 11unit
unit

Converting at Converting at
spot rate spot rate
1 SS0
S0
Investing at Loan Loan
Investing at
foreign rate repayment repayment
domestic rate
1
(1  i ) S0 (1  i )
S0
Reconverting at Reconverting at
spot rate spot rate
S1 S0
(1  i ) 1 i 1  i (1  i )
S0 S1
Uncovered margin Uncovered margin

S1 S0
(1  i )  (1  i ) (1  i )  (1  i  )
S0 S1
Uncovered Interest Parity
• To illustrate the mechanics of UIP, assume that
You have $AUD1 to invest in an Australian interest
earning asset
 You are a resident of Australia
 Earn a domestic interest rate equal to i, which is 5%
You can invest in a US-denominated interest earning
asset
 Earn a foreign interest rate equal to i*, which is 6%
Uncovered Interest Parity
• UIP states that the currency offering a higher rate of
interest should depreciate i  i*  S e
 When this is not the case, then there are arbitrage
opportunities
 Assume the US asset which is offering a higher return, is
not depreciating
 As such, the UIP condition is violated, and so open
arbitrage opportunities exist

Australia US
12 month interest rate 5% 6%
To invest $AUD 1 $AUD 1
S(AUD per US) 1.35
Amount invested $AUD 1 $USD 0.74
Value at end $AUD 1.05 $USD 0.79
Expected exchange rate 1.45
$AUD Value of Invest A$1.05 A$1.14
Combining PPP and Interest Parity
• An expectations form of PPP can be derived from
the relative form:
 
S  P P
e e  *e

• Compares with the UIP condition

S e  i  i*
we get  
i i  P  P
* e *e


iP i P
e *  *e
The Real Interest Parity (RIP) Condition
• The Fisher effect states that the nominal interest rate r
is made up of two components:
A real required rate of return
An inflation premium equal to the expected amount
of inflation
• The ex ante (expected) real interest rate is obtained by
subtracting the expected inflation rate from the nominal
interest rate

r iP
e e
The RIP Condition
• The Fisher effect would only work if the nominal
interest rate changes in proportion to inflation so that
the real interest rate remained unchanged.
• However, some empirical studies have shown that
real interest rates are not constant because nominal
interest rates do not adjust in full to changes in
inflation.
The Real Interest Parity (RIP) Condition
• RIP is used as an indicator of
The efficiency of goods and financial markets
The degree of integration of goods and capital
markets across countries
The degree of capital mobility
International Arbitrage and Parity Conditions
• The main macroeconomic variables are all linked by a series of
relationships
 PPP
 links the domestic goods market with the foreign goods market
 Unbiased efficiency
 Prices reflect all currently available information so that there are no
systematic patterns in the forecasting error
 CIP
 links the domestic financial market with that of the foreign financial
market, without any exchange rate risk
 UIP
 links the domestic financial market with that of the foreign financial
market, with complete exchange rate exposure
 RIP
 links both domestic financial and goods markets with that of the
foreign financial and goods markets