ARBITRAGE Definition: It involves no risk and no capital of your own.

It is an activity that takes advantages of pricing mistakes in financial instruments in one or more markets. The process of converting one currency to another, converting it again to a third currency and, finally, converting it back to the original currency within a short time span. This opportunity for risk-less profit arises when the currency's exchange rates do not exactly match up. There are 3 kinds of arbitrage (1) Local (sets uniform rates across banks) (2) Triangular (sets cross rates) (3) Covered (sets forward rates) Note: The definition we used presents the ideal view of (riskless) arbitrage. Arbitrage, in the real world, involves risk. Well call this arbitrage pseudo arbitrage. Local Arbitrage (One good, one market) Example: Suppose two banks in Dhaka have the following bid-ask FX quotes: Bank A Bank B Bid BDT/GBP 130 Ask 132 Bid 133 Ask 134

Sketch of Local Arbitrage strategy: (1) Borrow 132 BDT (2) Buy 1 GBP for 132 BDT from Bank A (3) Sell 1 GBP to Bank B for 133 BDT (4) Return BDT 132 and make a profit of 1 taka (0.75% per GBP on 132 taka borrowed) Note I: All steps should be done simultaneously. Otherwise, there is risk! (Prices might change). Note II: Both Bank A and Bank B will notice a book imbalance. Bank A will see all activity at the ask side (buy GBP orders) and Bank B will see all the activity at the bid side (sell GBP orders). They will notice the imbalance and theyll adjust the quotes. For example, Bank A can increase the ask quote to 133.50 BDT/GBP will leave no locational arbitrage opportunity. Triangular Arbitrage (Two related goods, one market) Triangular arbitrage is a process where two related goods set a third price. In the FX market, triangular arbitrage sets FX cross rates. Cross rates are exchange rates that do not involve the USD. Most currencies are quoted against the USD. Thus, cross-rates are calculated from USD quotations. The cross-rates are calculated in such a way that arbitrageurs cannot take advantage of the quoted prices. Otherwise, triangular arbitrage strategies would be possible. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or program to automate the process. Simply, triangular arbitrage process involves the following steps: Acquiring the domestic currency

Exchange the domestic currency for the common currency Convert the obtained units of the common currency into the second (other) currency Convert the obtained units of the other currency into the domestic currency.

Example: Suppose Bank One gives the following quotes: St = 100 JPY/USD St = 1.60 USD/GBP St = 140 JPY/GBP Take the first two quotes. Then, the implied (no-arbitrage) JPY/GBP quote should be SIt = 160 JPY/GBP At St = 140 JPY/GBP, Bank One undervalues the GPB against the JPY (with respect to the first two quotes). Sketch of Triangular Arbitrage (Key: Buy undervalued GPB with the overvalued JPY): (1) Borrow USD 1 (2) Sell the USD for JPY 100 (at St = 100 JPY/USD) (3) Sell the JPY for GBP (at St = 140 JPY/GBP). Get GBP 0.7143 (4) Sell the GPB for USD (at St = 1.60 USD/GBP). Get USD 1.1429 => Profit: USD 0.1429 (14.29% per USD borrowed). Note: Bank One will notice a book imbalance (all the activity involves selling USD for JPY, selling JPY for GBP, etc.) and will adjust the quotes. For example, will set St = 160 JPY/GBP. Again, all the steps in the triangular arbitrage strategy should be done at the same time. Otherwise, well be facing risk and what we are doing should be considered pseudo-arbitrage. Problem: If you find 1 USD equals to 85 BDT and 1 Euro equals to 110 BDT and you have found in another place 1 Euro is trading for 1.20 USD. If you have 1 million BDT how much money can you make from one arbitrage? Please draw a diagram. Solution: Before starting a triangular arbitrage, you must check the cross rate whether you could conduct an arbitrage. If the cross rate differs from the market rate then there is an arbitrage opportunity to make riskless profit. Here, 1 USD =85 BDT 1 Euro =110 BDT 1 Euro=1.20 USD 1000000 BDT
1078431.373 1000000 =PROFIT 78431.373 BDT

Sell 1000000 BDT and buy $11764.706 ($1= 85 BDT) SELL 9803.92 & BUY 1078431.373 BDT (1=110BDT)

$11764.70 9803.92
SELL $11764.706 AND BUY 9803.92 ($11764.7/1.2)

An arbitrager can make 78431.373 BDT by arbitraging one million BDT from one arbitrage. Problem: Suppose that the forward ask price for March 20 on euros is $0.9127 at the same time that the price of CME euro futures for delivery on March 20 is $0.9145. How could an arbitrageur profit from this situation? What will be the arbitrageur's profit per futures contract (contract size is 125,000)? Solution: Since the futures price exceeds the forward rate, the arbitrageur should sell futures contracts at $0.9145 and buy euro forward in the same amount at $0.9127. The arbitrageur will earn 125,000(0.9145 - 0.9127) = $225 per euro futures contract arbitraged. Problem: If you find 1 USD equals 86.5 BDT and 50 INR but you also find 1 INR is trading for 1.6 BDT. If you have 1 million BDT how much money can you make from one arbitraging? Please draw a diagram. Solution: Here, 1 USD=86.5 BDT (1081250 1000000) = 1 USD =50 INR PROFIT 81250 BDT 1 INR =1.6 BDT 1000000 BDT
SELL 1000000 BDT & BUY 625000 INR (1000000/1.6)

SELL 12500 USD & BUY 1081250 BDT (12500 x 86.5)

12500 USD
SELL 625000 INR & BUY 12500 USD (6250000/50)

625000 INR

From one arbitraging you can make 83750 BDT by investing 1 million BDT. Note: Before conducting triangular arbitraging you need to confirm whether there is an opportunity of doing it by finding the cross rate and if you find the cross rate is higher or lower the market rate only then you can start the process of triangular arbitrage. Problem: Suppose the euro is quoted in London at .6064-80 and the is quoted in Frankfurt at 1.6244-59. Is there a profitable arbitrage situation?

Solution:

London .6064-80/ Bid Ask

Frankfurt 1.6244-59/ Bid Ask

.6064 .6080

.6150 6156

Since the London Bid-Ask rate and Frankfurt Bid-Ask rate differs, yes! There is a profitable arbitrage opportunity exists. 1. Buy euros for .6080 / in London. 2. Use them in Frankfurt to buy pounds at 1.6259 (same as selling euros at .6150). 3. This is a net profit is .6150-.6080= .0070 per euros 4. A yield of 1.16% (.0070/.6080) The Interest rate Parity Theory Many factors affect the exchange rate, such as fiscal policy, monetary policy, the balance of payments position and its trends, current and expected inflation, interest rates, growth rates in GDP, central banks intervention, market expectation and speculators actions. The economic theories which link exchange rates, price levels (inflation), and interest rates together are called interest rate parity conditions. These theories may not always work out to be true when compared to what we observe in the real world, but they are central to any understanding of how multinational business is conducted. Implications of IRP If domestic interest rates are less than foreign interest rates , foreign currency must trade at a forward discount to offset any benefit of higher interest rates in foreign country to prevent arbitrage. IRP states that if foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset the interest rate advantage of foreign country, then arbitrage opportunity exists for domestic investors. In such case, domestic investors can benefit by investing in the foreign market.

If domestic interest rates are more than foreign interest rates , foreign currency must trade at a forward premium to offset any benefit of higher interest rates in domestic country to prevent arbitrage. For example, Japans bond yields around 2% whereas it is around 13% in Bangladesh. If the foreign currency (yen) does not trade at a forward premium or if the forward premium is not large enough to offset the interest rate advantage of domestic country and thus arbitrage opportunity will exist for Japanese investors. Foreign (Japanese) investors can benefit by investing in the domestic (Bangladesh) market If a country is financially closed or its financial sector lacks depth, liquidity and institutional development (for example, without well-functioning spot and forward currency markets), interest parities may not hold. There are two versions of interest parities: covered and uncovered. The covered version involves no exchange risks, while the uncovered version entails such risks and elements of speculation. Criticism of the theory of Interest Rate Parity The theory of interest rate parity is a very useful reference for explaining the differential between the spot and future exchange rate, and international movement of capital. Accepting this theory implies that international finance markets are perfectly competitive and function freely without any constraints. However, reality is much more complex. Some of the major factors that inhibit the theory from being put into practice are as follows: Availability of funds that can be unused for arbitrage is not infinite. We cannot outflow capital from Bangladesh since foreign exchange is heavily controlled. Further, the importance of capital movements, when they are available, depends on the credit conditions practiced between the financial places and on the freedom of actions of different operators as per the rules of the country. 705 Exchange controls certainly place obstacles in the way of theory of interest rate parity. The same is true about the indirect restrictions that can be placed on capital movement in the short run. Interest rate is only one factor affecting the attitude and the behavior of arbitrageurs. In other words, capital movements do not depend only on interest rates. Other important factors are concerned with liquidity and the case of placement. Speculation is an equally important element. This becomes very significant during the crisis of confidence in the future of currency. The crisis manifests in terms of abnormally high premium or discount much higher that what the interest rate parity can explain. The Interest Rate Parity theory suggests that any amount of exchange gains and losses incurred by the investor by simultaneously purchasing and selling in the spot and the forward markets, are generally offset by the interest rates differences on the similar type of assets. Under the said condition there is basically no incentive for the amount or capital to move in either direction because the total effective returns in the domestic market and the foreign market has equalized or came to equilibrium. Basically, this theory says that whenever there are differences in the forward and the spot rates with the differences in the interest rates between the two countries Arbitrage is possible and the covering of this sort of Arbitrage is referred to as Covered Interest Arbitrage. Covered Interest Arbitrage

Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries, while covering for exchange rate risk. Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials. So, to get the idea of covered interest Arbitrage the following steps are essential. 1) Firstly, the investor has to borrow the currency which as per the Interest Rate Parity has the lower interest rates. 2) After borrowing the currency having the lower interest rates, one has to calculate the payables at the end of the maturity period due to this borrowing. 3) Again now the amount which has been borrowed has to be converted in the other currency (which has not been borrowed), it means that the borrowed amount shall be converted into the other currency. 4) Now, the converted amount of the currency has to be invested in the prevailing interest rates, obviously it is such that the interest rates are higher at the time of investing in the other currency. 5) After the investment process is done, we have to calculate the amount of the receivables after the maturity of the investments basically in the higher interest rates. 6) Then we have to convert the receivables realised in the currency in which the borrowing has been made to calculate the amount of gain or losses. 7) Now we have to compare the step 2, (here the payables where calculated on maturity) and step 6, (here the receivables are calculated) and we would see that the amount received in step 6 would be higher than the amount received in step 2. This is basically what we refer to as a Covered Interest Arbitrage as all the conditions were fixed at the time of making the borrowings and in there are favourable fluctuations in the market then the investor can enjoy much more gains due to this. But factually, this fluctuation is for splits of time because a large number of investor comes to take the profit margin and then the interest rates and the currency rates comes to equilibrium, decreasing the arbitrage to a no arbitrage situation. Example: $ Interest rate = 2% for 90 days in US Interest rate = 3% for 90 days in UK Spot $/ = 1.50 90 day forward $/ = 1.50 Arbitrageur does the following: Step I Borrow $1.50 million in US for 90 days. Step II Convert to at the prevailing spot rate Le. 1.50 to get 1 million Step III Buy 90 days Deposit at UK Bank yielding 3% for 90 days. Step IV Sell 1.03 million forward [1 million + 0.03 million interest on deposit] at forward rate of 1.50 per . Step V At maturity he gets 1.03 million Step VI Against his forward contract selling which he has booked he would get 707 ____________ ______________________________ 1.50 1.03 = $1.545 million dollars Compare this with 1.50 1.02= $1.530 million dollars he would have got by depositing directly in US deposits. Thus he made a profit of $1.545 $1.530 = 0.015 million dollars i.e. $15000. Another example: In Bangladesh, government savings bond pays 13.25% annually whereas in Japan their Treasury bonds yield only 1%. So a Japanese investor could try to conduct a covered

Interest Arbitrage given he/she found Japanese yen is selling at 6% premium against BDT at the 1 year forward/future market and the Japanese investor locked in at that rate. Currently 1 BDT is trading on the spot almost at par that is 1 BDT equals to 1 Japanese yen. So a Japanese arbitrageur borrowed 1 million yen from a Japanese bank at say 3% interest rates since he/she wont get the same rate as low as governments Treasury bond. Now he/she converts to this 1 million yen to 1 million BDT since it is at par value. This 1 million BDT now invested in governments treasury bonds which earning 13.25% per annum. So after a year it will be: =1 m (1+ .1325) = 1.1325 million BDT. Now since he/she has sold the BDT at 6% discount at the 1 year forward rate which will give him/her: = 1.1325/ 1.06 = 1.068396 million yen. Now he/she would have to pay 1 million (1+.03) = 1.03 million yen to the Japanese bank and keep the 1.068396 1.03 = 38396 yen profit from 1 million yen arbitraging. Uncovered arbitrage is much the same, except that at the start they do not enter into a contract for a forward exchange rate back, meaning that they just have to invest back at the spot rate that is available to them at the end of the year long investment. This is no-where near as safe, but contrary to this there is a chance that the spot exchange rate at the end may be considerably higher or lower depending upon the market at the time and therefore meaning that an uncovered arbitrage may end up making you considerably more money, or the exact opposite. COVERED INTEREST PARITY (CIP) When people and firms are permitted to buy and sell foreign assets, they can hold various exchange "positions," which are net holding balances in foreign currency. The positions are classified below. Position "Long" "Short" Balance sheet situation Foreign assets > foreign liabilities Foreign assets < foreign liabilities Foreign assets = foreign liabilities If home currency depreciates Gain Loss No impact If home currency appreciates Loss Gain

"Open"

"Square"

For example, suppose you have foreign securities worth $500 but have also borrowed $700 from the bank. This means that you have the short position of $200. For simplicity, we assume all foreign assets and liabilities are denominated in USD. This allows us to concentrate on the movement of the domestic currency against USD, without worrying about the fluctuations among major currencies. Suppose you are a manufacturer of a certain product and also engaged in foreign trade. As you conduct your daily transactions of buying foreign parts or exporting finished products to foreign markets, the exchange position naturally fluctuates and does not remain "square." This means that you may incur gain or loss depending on the exchange rate movement at any moment, which is often hard to predict. Suppose also that your main business is manufacturing garments and you are not interested in foreign currency speculation. Particularly, you want to avoid exchange losses. If your country has sufficiently developed and externally open financial markets, there are two alternative ways to "cover" or "hedge"--i.e., make your exchange position square and avoid exchange risk. More concretely, assume that you are a Bangladeshi exporter of an industrial

product expecting a receipt of $100 after 3 months. You want to fix this receipt in terms of BDT now. Suppose also that: S (spot exchange rate) is currently $1=84 BDT F (3-month forward exchange rate) is--initially--$1=86 BDT i (BD interest rate) is 12%/year i* (US interest rate) is 6%/year The first method is forward cover. You go to a bank and make a forward contract today. That is to say, you agree to sell $100 to the bank after 3 months and receive a specified amount of BDT (86X100 =8600 BDT = $100) at that time. Then you wait for 3 months before executing this transaction. The exchange rate for selling USD in the future (forward rate, 86), offered by the bank, is different from the exchange rate for today (spot rate, 84). The second method is borrow dollar and sells spot now. That is to say, you go to a bank and borrow $97.09 today, immediately convert it to BDT (8155.56 BDT) in the spot market and deposit it at the bank in Bangladesh at 12% annual interest rate for 3 months. After 3 months, you withdraw 8,237.12 BDT (principal plus accrued interest) and simultaneously repay $100 (principal plus accrued interest) to the bank with the export receipt. Either way, you fix the yen receipt as of today so there is no exchange risk. But with the assumptions illustrated above, forward cover yields 10,200 yen and the borrowing method yields only 9,951 yen. Clearly, everyone prefers the first method. That means that the situation is not in equilibrium. If everyone tries to sell USD forward while no one buys USD forward, there will be an oversupply of forward dollar and its price will fall. It will fall until forward USD becomes precisely $1=99.51 yen; because at this rate, the first and second method will be equivalent. This is an example of financial arbitrage and LOOP. The same "commodity" (export receipt after three months' wait) obtained through the forward exchange market and the bank loan market now bears the same price. Needless to say, actual interest arbitrage occurs instantaneously, not sequentially and slowly. The CIP condition can be written as follows: (F-S)/S = (i-i*)/(1+i*) or approximately, (F-S)/S = i - i* if i* is sufficiently small. This means that F>S if and only if i > i* F<S if and only if i < i* In words, if the domestic interest rate is higher than the foreign interest rate, the forward exchange rate (future dollar) must be higher than the spot exchange rate (today's dollar), and vice

versa. This relationship should always hold among high-quality, low-risk financial instruments under capital mobility. Uncovered interest parity (UIP) UIP is very different from CIP. It involves exchange risk and speculation. In reality, UIP may or may not hold due to the existence of this uncertainty. Indeed, the bulk of empirical evidence suggests that it usually does not hold. Nevertheless, economists still use UIP because it is so convenient in model building. The idea of UIP is very simple. You have two options in financial investment: First option--purchase a domestic bond. Its return (in terms of domestic currency) is i. Second option--purchase a foreign bond. Its return (in terms of domestic currency) is i* + x. x is the expected change in the exchange rate from now to future. i and i* are certain but x is uncertain. While the first investment yields a certain return, the second does not (from the viewpoint of accounting based on the domestic currency). If you are risk-neutral (care only about the average return over many occasions instead of actual outcome this time), the LOOP condition for UIP is simply i = i* + x, or x = i - i* In words, the expected change in the exchange rate is equal to the bilateral interest rate gap. Note that, if both CIP and UIP hold simultaneously, we have x = (F-S)/S: that is to say, exchange rate expectation is equivalent to the forward premium. Three remarks are in order: (1) Exchange rate expectations are generally unobservable. According to studies, short-term expectations are often divergent (the current movement is assumed to continue) while long-term expectations are regressive. In plain English, market participants think that the current unusual movement is temporary and the exchange rate will later return to the original level. Furthermore, there is a large divergence of opinion among experts. Such divergence increases especially at the time of financial turbulence. (2) UIP can be decomposed into three parts: (i) purchasing power parity (PPP); (ii) the Fisher equation regarding the relationship between nominal and real interest rates; and (iii) free capital mobility in terms of equalized real interest rates (3) Investors may be risk-averse rather than risk-neutral. In other words, they worry about both the average return of their investment and the degree of certainty (or variance) of that return. To be induced to invest in a risky asset, they require a higher average return to compensate for increased uncertainty. Thus one could carry out a covered interest rate (CIA) arbitrage as follows, 1. Borrow $1 from the US bank at 5% interest rate. 2. Convert $ into at current spot rate of 1.5$/ giving 0.67 3. Invest the 0.67 in the UK for the 12 month period 4. Purchase a forward contract on the 1.5$/ (i.e. cover your position against exchange rate fluctuations) At the end of 12-months 1. 0.67 becomes 0.67(1 + 8%) = 0.72 2. Convert the 0.72 back to $ at 1.5$/, giving $1.08 3. Pay off the initially borrowed amount of $1 to the US bank with 5% interest, i.e $1.05

The resulting arbitrage profit is $1.08 $1.05 = $0.03 or 3 cents per dollar. Obviously, arbitrage opportunities of this magnitude would vanish very quickly. In the above example, some combination of the following would occur to reestablish Covered Interest Parity and extinguish the arbitrage opportunity: US interest rates will go up Forward exchange rates will go down Spot exchange rates will go up UK interest rates will go down