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  3. Lecture International finance: An analytical approach (3/e): Chapter 11 - Imad A. Moosa

Lecture International finance: An analytical approach (3/e): Chapter 11 - Imad A. Moosa

Chapter 11 - International arbitrage. In this chapter, the learning objectives are: To define arbitrage and the no-arbitrage condition; to describe two-point, three-point and multi-point arbitrage in the foreign exchange market; to describe commodity arbitrage;… Chapter 11 International Arbitrage Objectives • To define arbitrage and the no-arbitrage condition • To describe two-point, three-point and multi-point arbitrage in the foreign exchange market • To describe commodity arbitrage (cont.) Co

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  1. Chapter 11 International Arbitrage
  2. Objectives • To define arbitrage and the no-arbitrage condition • To describe two-point, three-point and multi-point arbitrage in the foreign exchange market • To describe commodity arbitrage (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-2
  3. Objectives (cont.) • To describe covered interest arbitrage and show how the no-arbitrage condition can be used to determine the forward exchange rate • To describe uncovered arbitrage and introduce the concept of carry trade Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-3
  4. Definition of arbitrage • Arbitrage is generally defined as capitalising on a discrepancy in quoted prices as a result of the violation of an equilibrium (no-arbitrage) condition • The arbitrage process restores equilibrium via changes in the supply of and demand for the underlying commodity, asset or currency (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-4
  5. Definition of arbitrage (cont.) • The importance of arbitrage is that no-arbitrage conditions are used for asset pricing, such that the equilibrium price of a financial asset is the price that is consistent with the underlying no-arbitrage condition Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-5
  6. Two-point arbitrage • Also known as spatial or locational arbitrage, it arises when the following condition is violated: S A ( x / y) SB ( x / y) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-6
  7. Two-point arbitrage with bid-offer spreads • With bid-offer spreads the no-arbitrage condition becomes: Sb , A x / y Sa, B x / y Sa, A x / y Sb , B x / y Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-7
  8. Three-point (triangular) arbitrage • It is triggered when cross exchange rates are inconsistent, that is, when the following condition is violated: S ( x / z) S ( x / y) S ( y / z) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-8
  9. Profitable/unprofitable sequences (a) Unprofitable sequence (b) Profitable sequence x x S ( x / z) S ( x / y) S ( y / z) z y z y Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-9
  10. Multipoint arbitrage • The condition precluding multipoint arbitrage is: S ( x1 / x2 ) S ( x2 / x3 ) S ( xn / x1 ) 1 Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-10
  11. Five-point arbitrage AUD EUR USD   GBP JPY Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-11
  12. Commodity arbitrage • The no-arbitrage condition in the case of commodity arbitrage is the law of one price (LOP): * Pi SPi (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-12
  13. Commodity arbitrage (cont.) • Commodity arbitrage is conducted by buying a commodity in a market where it is cheap and selling it in a market where it is more expensive Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-13
  14. Covered interest arbitrage • Covered interest arbitrage is triggered by the violation of the covered interest parity (CIP) condition, which describes the equilibrium relation between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-14
  15. Return on Investments Investor (K) Foreign Domestic investment investment Converting at  spot rate K    S Investing in  foreign assets K    (1 i ) S Reconverting at  forward rate KF K (1 i ) (1 i ) S Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-15
  16. The CIP equilibrium condition F (1 i ) (1 i ) S i i f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-16
  17. Covered interest arbitrage Domestic   foreign Foreign   domestic Borrowing  Borrowing  domestic currency foreign currency 1 unit   1 unit   1 unit   Converting at  Converting at  spot rate spot rate 1 S        S S Investing at  Loan  Loan  Investing at  foreign rate repayment repayment domestic rate 1 (1 i ) S   (1 i ) S Reconverting at  Reconverting  forward rate at forward rate F S (1 i )    1 i 1 i (  1 i ) S F Covered margin Covered margin F S (1 i ) (1 i ) (1 i ) (1 i ) S F Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-17
  18. Profit from covered arbitrage (domestic→foreign) F π (1 i ) (1 i ) S π i i f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-18
  19. The interest parity forward rate 1 i F S 1 i Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-19
  20. Covered arbitrage with bid-offer spreads (domestic→foreign) Fb π (1 ib ) (1 ia ) Sa π ib ia f m Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A. Moosa Slides prepared by Afaf Moosa 11-20
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