Arbitrage: Foreign Exchange Market and Rate
Chapter 7
International Arbitrage and Interest Rate Parity Lecture Outline
International Arbitrage
Locational Arbitrage Triangular Arbitrage 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? Considerations When Assessing Interest Rate Parity Changes in Forward Premiums
Chapter Theme
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
1. Why are quoted spot rates very similar across all banks? 2. Why don't arbitrage opportunities exist for long periods of time? 3. 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? 4. Provide current interest rates of two countries and ask students to determine the forward rate that would be expected according to interest rate parity. Critical debate Should arbitrage be more regulated? Proposition 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
International Arbitrage and Interest Rate Parity Lecture Outline
International Arbitrage
Locational Arbitrage Triangular Arbitrage 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? Considerations When Assessing Interest Rate Parity Changes in Forward Premiums
Chapter Theme
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
1. Why are quoted spot rates very similar across all banks? 2. Why don't arbitrage opportunities exist for long periods of time? 3. 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? 4. Provide current interest rates of two countries and ask students to determine the forward rate that would be expected according to interest rate parity. Critical debate Should arbitrage be more regulated? Proposition 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