International Arbitrage - nirmalsoni.files.wordpress.com€¦ · Locational Arbitrage 1. Defined as the process of buying a currency at the location where it is priced cheap and immediately

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International Arbitrage

1. Defined as capitalizing on a discrepancy in quoted prices by making a riskless profit.

2. Three forms of arbitrage:a. Locational arbitrageb. Triangular arbitragec. Covered interest arbitrage

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Locational Arbitrage

1. Defined as the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher.

2. Gains from locational arbitrage are based on the amount of money used and the size of the discrepancy.

3. Realignment due to locational arbitrage drives prices to adjust in different locations so as to eliminate discrepancies.

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Exhibit 7.2: Locational Arbitrage

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Triangular Arbitrage

1. Defined as currency transactions in the spot market to capitalize on discrepancies in the cross exchange rates between two currencies.

2. Accounting for the Bid/Ask Spread: Transaction costs (bid/ask spread) can reduce or even eliminate the gains from triangular arbitrage.

3. Realignment due to triangular arbitrage forces exchange rates back into equilibrium.

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Exhibit 7.3 Example of Triangular Arbitrage

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Covered Interest Arbitrage

1. Defined as the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract.

2. Consists of two parts:a. Interest arbitrage: the process of capitalizing on the

difference between interest rates between two countries.b. Covered: hedging the position against interest rate risk.

3. Realignment due to covered interest arbitrage causes market realignment.

4. Timing of realignment may require several transactions before realignment is completed.

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Exhibit 7.7 Example of Covered Interest Arbitrage

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Exhibit 7.8 Comparing Arbitrage Strategies

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© 2010 South-Western/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 forclassroom use.