CHAPTER 7 International Arbitrage And Interest Rate Parity

Chapter Overview A. International Arbitrage B. Interest Rate Parity (IRP)

Chapter 7 Objectives This chapter will: A. Explain the conditions that will result in various forms of international arbitrage, along with realignments that will occur in response to various forms of international arbitrage B. Explain the concept of interest rate parity and how it prevents arbitrage opportunities

A. International Arbitrage 1. Locational Arbitrage a. Gains from Locational Arbitrage b. Realignment due to Locational Arbitrage

Locational Arbitrage Exhibit 7. 2

A. International Arbitrage 2. Triangular Arbitrage a. Accounting for the Bid/Ask Spread b. Realignment due to Triangular Arbitrage Triangular arbitrage would force the exchange rates back into equilibrium

Example of Triangular Arbitrage Exhibit 7. 3

A. International Arbitrage 3. Covered Interest Arbitrage a. Realignment due to Covered Interest Arbitrage: As with the other forms of arbitrage, market forces resulting from covered interest arbitrage will cause a market realignment b. Consideration of Spreads

Example of Covered Interest Arbitrage 7. 7

B. Interest Rate Parity (IRP) 1. Derivation of Interest Rate Parity 2. Determining the Forward Premium a. Relationship between Forward Premium and Interest Rate Differential b. Implications

B. Interest Rate Parity (IRP) 3. Graphic Analysis of Interest Rate Parity a. Points Representing a Discount b. Points Representing a Premium c. Points representing IRP d. Points below the IRP Line e. Points above the IRP Line

Illustration of Interest Rate Parity 7. 9

B. Interest Rate Parity (IRP) 4. How to Test Whether Interest Rate Parity Exists 5. Interpretation of Interest Rate Parity 6. Does Interest Rate Parity Hold?

B. Interest Rate Parity (IRP) 7. Consideration When Assessing Interest Rate Parity a. Transaction Costs b. Political Risk c. Differential Tax Laws 8. Forward Premiums across Maturity Markets 9. Changes in Forward Premiums