Financial Markets and Institutions Week 7: Lecture 2 - Interest Arbitrage and PPP Flashcards
(20 cards)
Types of International Arbitrage
Arbitrage: Capitalizing on price discrepancies to earn risk-free profit.
In international finance, arbitrage takes three forms:
1. Locational Arbitrage:
Exploits differences in exchange rates between banks in different locations.
Rule: Arbitrage is possible if bid price at one bank > ask price at another.
Note (Slide 5): Buy from the stronger currency bank, sell to the weaker.
2. Triangular Arbitrage:
Exploits discrepancies in cross exchange rates.
Involves converting through three currencies to make a profit.
3. Covered Interest Arbitrage (CIA):
Transfers funds to a country with a higher interest rate.
Uses a forward contract to eliminate exchange rate risk.
When is locational arbitrage possible and how is profit calculated?
Condition:
Arbitrage is possible if:
Bid price at Bank A > Ask price at Bank B
Note (Slide 6): Assumes no transaction or transportation costs.
Example (Slide 8):
What is covered interest arbitrage and how does it eliminate exchange rate risk?
CIA: Investing in a foreign country with a higher interest rate, while using a forward contract to eliminate exchange rate risk.
Steps:
Convert home currency to foreign currency at spot rate.
Invest in foreign country at foreign interest rate.
Lock in forward rate to convert back to home currency.
Note (Slide 9):
Without a forward contract, you’re exposed to foreign exchange risk (uncovered interest arbitrage (UIA)).
CIA covers this risk.
Example:
Spot and forward rate = $1.60/£
US interest rate = 2%, UK = 4%
Borrow $ or use existing funds, convert to £, invest at 4%, and lock in forward rate to convert back.
How is profit from CIA calculated and what forces eliminate CIA opportunities?
What is interest rate parity and how does it relate to covered interest arbitrage?
Interest Rate Parity (IRP): A condition where the forward rate premium/discount offsets the interest rate differential between two countries.
When IRP holds:
Covered interest arbitrage (CIA) is not profitable.
Investors earn the same return whether they invest at home or abroad (after covering FX risk).
Violation of Interest Rate Parity
If IRP is violated, arbitrage opportunities arise:
Investors borrow in the low-interest currency.
Convert at the spot rate.
Invest in the high-interest currency.
Lock in a forward contract to convert back.
Profit is made if the forward rate does not fully offset the interest rate differential.
Arbitrage continues until:
Interest rates adjust.
Forward rate adjusts.
IRP is restored.
Implications and Interpretation of IRP
When IRP holds:
Investors cannot earn excess returns through CIA.
The forward rate reflects the interest rate differential.
Interpretation:
IRP does not mean returns are equal across countries.
It means returns are equal after hedging FX risk.
Empirical Evidence:
IRP generally holds well in practice.
Deviations are usually too small to exploit after accounting for:
Transaction costs
Political risk
Tax differences
Deriving Interest Rate Parity (IRP)
What is the International Fisher Effect and how does it relate to exchange rates?
Implication:
High-interest currencies are expected to depreciate.
Low-interest currencies are expected to appreciate.
Used in carry trade: Borrow low-interest currency, invest in high-interest one.
Covered Interest Arbitrage and the Interest Parity Line
In Covered Interest Arbitrage (CIA), the interest parity line represents where the interest rate differential equals the forward premium/discount.
Above the parity line:
A positive interest differential exceeds the forward premium (Point B).
A negative interest differential is smaller than the forward discount (Point B′).
In both cases, it is profitable for foreigners to invest in the home country.
Graph interpretation:
X-axis: Forward Discount (−) / Premium (+)
Y-axis: Interest differential (i − i*)
CIA Outflow: Points A and A′ (investors move funds abroad).
CIA Inflow: Points B and B′ (foreigners invest in home country).
Explain the concept of the Carry Trade and its implications for IRP.
Carry Trade:
Investors borrow in low-interest currencies and invest in high-interest currencies to profit from the interest rate differential.
Profitable over long periods, especially when interest differentials are large.
Implications for IRP:
Suggests Interest Rate Parity (IRP) does not always hold in practice.
IRP assumes no arbitrage profits, but carry trade profits challenge this.
Risks:
High-interest currencies may crash abruptly, causing large losses.
Ongoing Debate:
Economists are still exploring whether carry trade success requires new theoretical explanations beyond IRP violations.
Discuss the concept of FX market efficiency and its implications.
Market Efficiency: Prices reflect all available information.
In FX markets, efficiency means forward rates should be unbiased predictors of future spot rates.
Empirical Evidence: Mixed — some support, some show predictable deviations.
Implication: If efficient, speculative profits should be rare and short-lived.
What are Eurocurrency and Offshore Financial Markets?
Eurocurrency: Deposits held in a currency outside its country of origin.
Examples:
Eurodollar: USD in a British bank.
Eurosterling: GBP in a French bank.
Eurodeposit: EUR in a Swiss bank.
Why they exist:
Higher interest rates abroad.
Convenience for international firms.
Avoid domestic credit restrictions.
Eurobonds: Long-term debt sold outside the borrower’s country in a foreign currency.
Euronotes: Medium-term borrowing instruments used by corporations, banks, and countries
Explain the theory of PPP and its implications for exchange rates.
Relative PPP Theory
Evaluate the Big Mac Index as a tool for assessing PPP.
Big Mac Index (The Economist, 1986):
Compares Big Mac prices globally to assess currency valuation.
Uses prices to calculate implied PPP exchange rates.
Example: If a Big Mac is $5 in the US and ¥500 in Japan, implied PPP = 100¥/$.
Purpose: Highlights deviations from PPP in a simple, relatable way.
Derive PPP and explain its relationship with inflation differentials.
If home inflation > foreign inflation → home currency should depreciate.
Formula: ebottom rightf = (1+inflbottom righth)/(1+inflbottom rightf) - 1
Simplified: ebottom rightf ~=inflbottom righth - inflbottom rightf
Graphic Analysis of PPP
- At point C, home customers purchase more foreign goods because they’re cheaper. Overtime, this would put a lot more pressure on the exchange rate to bring it back to the 45 degree line
Discuss the long-run determinants of exchange rates.
Relative Price Levels: Higher prices → depreciation.
Tariffs & Quotas: More trade barriers → appreciation.
Preferences: More demand for domestic goods → appreciation.
Productivity: Higher productivity → appreciation.
Evaluate the limitations of PPP in real-world application.
Confounding Effects: Interest rates, income, government controls, expectations.
Lack of Substitutes: Some goods aren’t easily traded.
Empirical Evidence:
Works well: Traded commodities, long periods, inflationary shocks.
Less well: All traded goods, medium term.
Poorly: Non-traded goods, short run, structural change.
