International Arbitrage and Interest Rate Parity
Covered Interest Arbitrage
Comparison of Arbitrage Effects
Interest Rate Parity
Derivation of Interest Rate Parity
Determining the Forward Premium
Graphic Analysis of Interest Rate Parity
How to Test Whether Interest Rate Parity Exists
Interpretation of Interest Rate Parity
Does Interest Rate Parity Hold?
Forward Premiums Across Maturity Markets
Considerations When Assessing Interest Rate Parity
Changes in Forward Premiums
International Financial Management
This chapter illustrates how three types of arbitrage (locational, triangular, and covered interest) are
executed. Emphasize that the key to arbitrage from an MNC’s perspective is not the potential profits,
but the relationships that should exist due to arbitrage. The linkage between covered interest arbitrage
and interest rate parity is critical.
Topics to Stimulate Class Discussion
Why are quoted spot rates very similar across all banks?
Why don’t arbitrage opportunities exist for long periods of time?
Present a scenario and ask whether any type of international arbitrage is possible. If so, how
would it be executed and how would market forces be affected?
Provide current interest rates of two countries and ask students to determine the forward rate that
would be expected according to interest rate parity.
Does Arbitrage Destabilize Foreign Exchange Markets?
POINT: Yes. Large financial institutions have the technology to recognize when one participant in the
foreign exchange market is trying to sell a currency for a higher price than another participant. They
also recognize when the forward rate does not properly reflect the interest rate differential. They use
arbitrage to capitalize on these situations, which results in large foreign exchange transactions. In
some cases, their arbitrage involves taking large positions in a currency, and then reversing their
positions a few minutes later. This jumping in and out of currencies can cause abrupt price
adjustments of currencies and may create more volatility in the foreign exchange market. Regulations
should be created that would force financial institutions to maintain their currency positions for at
least one month. This would result in a more stable foreign exchange market.
COUNTER-POINT: No. When financial institutions engage in arbitrage, they create pressure on the
price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing
discrepancies would become more pronounced. Consequently, firms and individuals who use the
foreign exchange market would have to spend more time searching for the best exchange rate when
trading a currency. The market would become fragmented, and prices could differ substantially among
banks in a region, or among regions. If the discrepancies became large enough, firms and individuals
might even attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a
This is the end of the preview. Sign up
access the rest of the document.