Document Date: November 2, 2006

An Introduction To Derivatives And Risk Management, 7th Edition

Don Chance and Robert Brooks
Technical Note: More on Interest Rate Parity, Ch. 10, p. 345
This technical note supports the material in the Foreign Exchange Arbitrage
section of Chapter 10 Futures Arbitrage Strategies. We provide various ways to illustrate
covered interest arbitrage with a numerical example. The basic information is as follows:
Suppose the U. S. interest rate for the next year months is 1.5 percent (annual rate). The
euro interest rate is 2 percent (annual rate). The spot price of the euros in dollars is
$1.665/€. The futures price is $1.664/€.

Covered interest arbitrage – superior rate of return approach

Based on interest rate parity, the correct futures price is given by

f 0 (T ) = S 0
(1 + r )T = 1.665(1.015)/(1.02) = 1.6568.
(1 + ρ)T
Because the market futures price ($1.664/€) is higher than the model price ($1.6568/€),
we will sell the futures contract. Simultaneously, we will buy the foreign currency in the
spot market at $1.665/€ and sell it in the futures market at $1.664/€. We will earn interest
at the foreign interest rate of 2 percent.
By selling futures, we then convert back to dollars at the rate of $1.664/€. In
other words, $1.665 would be used to buy €1, which would grow to €1.02 (recall the 2
percent foreign rate). Then €1.02 would be converted back to €1.02($1.664/€) =
$1.69728. This would be a return of $1.69728/$1.665 - 1 = 0.019387 or 1.9 percent,
which is better than the U. S. rate of 1.015 percent. Hence, this line of reasoning is
termed the superior rate of return approach. There are a couple of alternative
perspectives of the same arbitrage strategy.

Covered interest arbitrage – cash flow table approach

The cash flow table approach is based on illustrating arbitrage profits available
when interest rate parity does not hold. The cash flow table below illustrates the
arbitrage strategy. We assume here the purchase of the foreign currency (euros) would
be financed at the domestic interest rate of 1.5 percent, resulting in a zero net investment.
Remember everything in this table is cash flow and not “investment.”
 Strategy Today (t = 0) Futures Expiration (t = 1)
Sell FX futures $0 (only margin +f(1) - S1
required) = $1.664/€ - S1
Buy discounted spot -($1.665/€)/(1 + r€) +S1(1 + r€)/(1 + r€)
FX and invest at = -$1.63235/€ = +S1
foreign rate
Borrow discounted +$1.63235/€ -$1.656835/€
spot FX (= -$1.63235*(1 + 0.015))
NET CASH FLOW $0 $1.664/€ - $1.656835/€
= $0.007165/€

Thus, this table illustrates the riskless profits available to the arbitrageur when interest
rate parity does not hold. Note that the dollar amount of arbitrage ($0.007165) is based
on the dollar investment of $1.63235 today (or the present value of €1).

Covered interest arbitrage – “four dots” approach

The four dots approach is based on visually considering four locations on a page
(t = 0 in US, t = 0 in FC, t = T in US, and t = T in FC), illustrated below. The “dots” are
the squares in the illustration. The goal is to transport one unit of domestic currency
starting at t = 0 to end up with domestic currency at t = T. There are two strategies:
1) Deposit the money in the domestic bank and earn the domestic risk-free
interest rate (denoted 1,1 in the illustration for strategy 1 and trade 1).
2) Convert the domestic currency to foreign currency (2,1), invest in foreign
bank (2,2), enter a futures contract to sell foreign currency at t = T (2,3).

IDRM7e, © Don M. Chance and Robert-Brooks 2 More on Interest Rate Parity

 DOMESTIC FOREIGN

t=0 2,1 t=0

US FC

1,1
2,2

t=T t=T
US FC
2,3

We return now to the numerical example. We know the spot foreign exchange
rate is S0 = $1.665/€, the domestic interest rate is rDC = 1.5 percent, and the euro rate is
r€ = 2 percent. To design carry arbitrage, we consider two trading strategies. Strategy 1
is investing $1 in a US bank (1,1). Strategy 2 is investing $1 in a euro-denominated bank
(2,2), first converting the $1 to the € (2,1). Also, Strategy 2 requires hedging the foreign
currency risk by selling the appropriate amount of foreign currency at the futures foreign
exchange rate (2,3). Recall the one-year foreign exchange futures price is $1.664/€.
These transactions are illustrated below.

IDRM7e, © Don M. Chance and Robert-Brooks 3 More on Interest Rate Parity

 DOMESTIC FOREIGN

t=0 €
t=0 US 2,1 $1 * S0(€/$)
$1 = €(1/1.665)

1,1
2,2

t=1 US t=1 €
Strategy 1 $1 * S0(€/$) * (1+r€)
$1 * (1+rDC) = €(1/1.665)*(1+0.02)
=$1*(1+0.015)=$1.015 2,3
Strategy 2
$1 * S0(€/$) * (1+r€)*f0(T)
= €(1/1.665)*(1+0.02) ($1.664/€)
=$1.019387

Because Strategy 2 results in a higher value than Strategy 1, we will go “long”

Strategy 2 and “short” Strategy 1 or:
1) Enter foreign exchange futures contract to buy $ (amount €(1/1.665)(1.02)),
2) Buy spot FX ($1 or €(1/1.665)), and
3) Borrow $1 in U.S.
The net profit will be $1.019387 (proceeds from Strategy 2) less $1.015 (cost of being
short Strategy 1) or $0.004387.
The difference in quantity of arbitrage profit from the two methods above is
merely a function of dollar amount initially invested. Using the cash flow table we
invested $1.63235 and using the four dots method we invested $1. Notice that 163.235
percent of the arbitrage in the four dots method is $0.00716 (= 1.63235*$0.004387), the
dollar arbitrage with the cash flow table. There is a slight difference due to rounding
errors.

IDRM7e, © Don M. Chance and Robert-Brooks 4 More on Interest Rate Parity