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Chapter 7
International Arbitrage and Interest Rate Parity
Lecture Outline
Locattional Arbitrage
Gains from Locational Arbitrage
Realignment Due to Locational Arbitrage
Covered Interest Arbitrage
Comparison of Arbitrage Effects
Triangular Arbitrage
Gains from Triangular Arbitrage
Realignment due to Triangular Arbitrage
Covered Interest Arbitrage
Steps Involved in Covered Interest Arbitrage
Realignment Due to Covered Interest Arbitrage
Arbitrage Example When Accounting for Spreads
Covered Interest Arbitrage by Non-U.S. Investors
Comparing Different Types of Arbitrage
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
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?
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.
