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ASSIGNMENT ON
INTERNATIONAL ARBITRAGE
AND
COVERED INTEREST RATE ARBITRAGE
1. The same asset does not trade at the same price on all markets/
2. Two assets with identical cash flows do not trade at the same price.
3. An asset with a known price in the future does not today trade at its
future price discounted at the risk-free interest rate.
TYPES OF ARBITRAGES
1. International arbitrage
2. Currency Arbitrage
3. Covered Interest Arbitrage
4. Uncovered Interest Arbitrage
5. Merger Arbitrage
6. Option Arbitrage
7. Equity Arbitrage
8. Stock Arbitrage
9. Fixed income Arbitrage etc.
Since international arbitrage relies on the buying and selling at nearly the same
time, this process has increased as computers and technology allow for instant
EXAMPLE
LHS = (1+rh)
RHS =F/S *(1+rf)
When LHS is not = RHS à Arbitrage exists
• If LHS <RHS --One would borrow home currency, convert receipts to
foreign currency at spot rate, invest in for. Currency denominated
securities 9as Foreign Securities carry higher Interest). At the same time
he will cover his principal and interest from this investment at the
forward rate. At maturity, he would convert the proceeds of the foreign
investment at a prefixed forward rate and payoff the domestic liability.
The difference between the receipts and payments serve as profit to the
customer.
• If LHS > RHS ,One would borrow , foreign currency, convert receipts to
domestic currency at a prevailing rate ( Spot ), invest in domestic
currency denominated securities (as domestic securities carry higher
interest). At the same time he would cover his principal and interest
from this investment at the forward rate. At maturity, he would convert
the proceeds of the domestic investment at the prefixed domestic
forward rate and payoff the foreign liability. The difference between
receipts and payments serve as profit to customer.
Interest rate parity is a non-arbitrage condition which says that the returns
from borrowing in one currency, exchanging that currency for another currency
and investing in interest-bearing instruments of the second currency, while
simultaneously purchasing futures contracts to convert the currency back at
the end of the holding period, should be equal to the returns from purchasing
and holding similar interest-bearing instruments of the first currency. If the
returns are different, an arbitrage transaction could, in theory, produce a risk-
free return.
Looked at differently, interest rate parity says that the spot price and the
forward, or futures price, of a currency incorporate any interest rate
differentials between the two currencies assuming there are no transaction
costs or taxes.
When IRP exist, the rate of return achieved from CIA should equal the rate of
return available in home country.
Arbitrage opportunity does not remain available for a long period. Market
forces correct to make a balance (Fischer Equation).
If RHS>LHS, following changes will happen:
CONCLUSION
• The International Fischer equation explains why investments across the
world are balanced.
• The differences in interest rate of different countries occur to capture
the risk profile of different economies.
• If there are changes in the interest rates in one country, other countries
are also bound to make a change in their interest rates to avoid huge
demand for one particular currency.
• Covered Interest Arbitrage is the exploitation of the IRP and is used and
can be used by the investors only for the short term investments.