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
Variation in Forward Rate Premiums
Forward Premiums Across Maturities
Changes in Forward Premiums Over Time
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?
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International Arbitrage and Interest Rate Parity 2
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.
POINT/COUNTER-POINT:
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 more integrated
foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line
with the market.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: The counter-point is correct. The type of arbitrage mentioned in this chapter is necessary to
have consistent foreign exchange quotations among the financial institutions that serve as dealers in the
foreign exchange market. Arbitrage does not destabilize the foreign exchange market.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.