Arbitrage: Foreign Exchange Market and Rate

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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 Changes in Forward Premiums

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. Critical debate Should arbitrage be more regulated? Proposition 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. Opposing view 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. With whom do you agree? State your reasons. Use InfoTrac or search engines recommended by your institution to access academic journals subscribed to by your institution. The keyword “arbitrage” is probably the best means of selecting relevant articles. Such articles often conduct statistical tests of some sophistication. It is the conclusions from these tests and the debate surrounding their design and the literature review that is the real contribution to the debate. Do not be put off by the rather more obscure aspects of the statistical tests. For this subject, newspapers are not a good source as they often confuse speculation with arbitrage. Speculation is considered in the next chapter.

ANSWER: The opposing is correct assuming market efficiency. The type of arbitrage mentioned in this chapter is necessary to have consistent foreign...
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