International Arbitrage and Interest Rate Parity

983 Words Apr 8th, 2013 4 Pages
Within the foreign exchange market there are times where currency prices are misquoted. The misquoted prices can lead to an inaccuracy within the foreign market exchange. However, the market will readjust itself by international arbitrage which is the act of capitalizing on the divergence of misquoted prices by creating a riskless profit. Arbitrage is a strategy that investors use to not have to make an investment which includes no risk or funds being tied to a certain asset. There are three forms of international arbitrage: location arbitrage, triangular arbitrage and covered interest arbitrage.
Location arbitrage is a process where a participant of the foreign exchange can go to one place, bank in a specified location, to purchase a
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However, the realignment does not cause investors who have gained from arbitrage to loss their gains since they had obtained a forward contract on the day they made their investment. The act to sell the other currency forward would place a downward pressure on the currency but not enough to lessen or completely offset the benefits of the interest rate advantage. In the process of covered interest arbitrage only the forward rate is affected. It is possible for the spot rate to appreciate but the forward rate would not have to decline by as much. Overall, since the forward market is less liquid, the forward rate is more sensitive to market changes and there is likely to experience most or all of the adjustments need to realign the market.
Once there are no opportunities of arbitrage because the prices of currencies have adjusted to where they should be based on the market, there is an equilibrium state referred to as interest rate parity (IRP). In equilibrium, the forward rate differs from the spot rate by a large amount to offset the interest rate difference between the two countries. The relationship between a forward premium for a foreign currency and the interest rates representing these currencies according to IRP can be determined by the following variables: Ah : The amount of the home currency that is initially invested S : The spot rate in the home currency when the foreign currency is purchased if : The interest rate on the foreign deposit F :
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