Lecture 04 2017

Week 4
Speculation, Arbitrage and

Interest Rate Parity
5 Currency Derivatives
Chapter Objectives
▪ Explain how forward contracts are used to hedge based

on anticipated exchange rate movements
▪ Describe how currency futures contracts are used to
speculate or hedge based on anticipated exchange rate
movements
▪ Explain how currency option contracts are used to
speculate or hedge based on anticipated exchange rate
movements
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Speculation (Direction)
Spot Market & FX Options
• Speculation: holding an uncovered position
• Choice of Investment depends upon Speculator’s
Expectations:
• Foreign currency appreciation
 Desire a Long Exposure
Buy foreign currency
Long FX forward / futures
Buy FX call option
• Foreign currency depreciation
 Desire a Short Exposure
Sell foreign currency
Sell FX forward / futures
Buy a FX put option
• Magnified results: Leverage / Derivatives

Currency Futures Market
Speculation with Currency Futures

▪ Efficiency of the currency futures market
▪ If the currency futures market is efficient, the futures price
should reflect all available information.
▪ Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead to
abnormal profits.
▪ Research has found that the currency futures market may be
inefficient. However, the patterns are not necessarily
observable until after they occur, which means that it may be
difficult to consistently generate abnormal profits from
speculating in currency futures.
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4 permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Currency Call Options
Speculating with Currency Call Options

▪ Individuals may speculate in the currency options based
on their expectations of the future movements in a
particular currency.
▪ Speculators who expect that a foreign currency will
appreciate can purchase call options on that security.
▪ The net profit to a speculator is based on a comparison of
the selling price of the currency versus the exercise price
paid for the currency and the premium paid for the call
option.
Currency Call Options
Speculating with Currency Call Options (cont.)

▪ Break-even point from speculation
▪ Break even if the revenue from selling the currency equals
the payments made for the currency plus the option
premium.
▪ Speculation by MNCs.
▪ Some institutions may have a division that uses currency
options to speculate on future exchange rate movements
▪ Most MNCs use currency derivatives for hedging and not
speculation.
Currency Put Options
Speculating with Currency Put Options

▪ Individuals may speculate with currency put options based on
their expectations of the future movements in a particular
currency.
▪ Speculators can attempt to profit from selling currency put
options. The seller of such options is obligated to purchase
the specified currency at the strike price from the owner who
exercises the put option.
▪ The net profit to a speculator is based on the exercise price at
which the currency can be sold versus the purchase price of
the currency and the premium paid for the put option..
Options Leverage Effect
• Australian Speculator
– Has 1000 AUD
– Believes the GBP is going to appreciate versus the AUD
– Spot rate: GBP / AUD 1.42
– Call option strike price: 1.42 --- (Premium = 2c AUD)
Example 1 (Spot) Example 2 (Options)

Buy 704 GBP @ S0 Buy call options on 50,000 GBP
Cost = 1000 AUD Premium = .02 AUD per GBP
= (.02)(50000)
= 1000 AUD
GBP appreciates to 1.50 at time ‘t’
Sell 704 GBP @ St Exercise call option
Payoff = (St – X) 50,000
Receive 1056 AUD = 4000 AUD
Return = 5.6% Return = 300% (4000-1000) / 1000

N.B. When speculating, you must also consider the opportunity cost (difference between Aus. & UK interest rates)
Options Leverage Effect
GBP appreciates to 1.43
Sell 704 GBP @ St Exercise call option
Payoff = (St – X) 50,000
Receive 1007 AUD = 500 AUD
Return = 0.7% Return = -50% (500-1000) / 1000
GBP depreciates to 1.36

Sell 704 GBP @ St Option OTM
Payoff = 0
Receive 957 AUD
Return = -4.3% Return = -100% (0-1000) / 1000
N.B. When speculating, you must also consider the opportunity cost (difference between Aus. & UK interest rates)
Market Expectations
Our previous options speculators had a simplistic view of
the market
CONCEPT:
In an efficient market expected movements are
already incorporated into the prices of our derivative
instruments.
• Eg. Lock in the forward rate.
Thus when speculating with regards to direction using

market priced instruments, you should actually be
picking the direction relative to market expectations
• Eg. The market expects the value of the Pound to depreciate.
– Depending on your own forecasts, this could be a signal to
either buy or sell pounds in the forward market.
Speculation (Direction)
Example: Forward Market
• Spot : GBP / AUD 1.79
• 6 month Forward Rate : 1.85
(1) Australian speculator’s belief

GBP is going to appreciate vs. the AUD to 1.92
Action : Buy GBP Forward
(2) Australian speculator’s belief

GBP is going to appreciate vs. the AUD to 1.82
Action : Sell GBP Forward
Speculation (Volatility)
• Options markets allow traders to take advantage of their
expectations regarding volatility.
– Volatility is a factor in the value of options.
• Example:
– Where the hedger’s expectation is that the volatility is
going to be greater than the market prediction, a hedger
can lock in a forward rate to cover their exposure with
respect to direction and use a ‘Straddle’ as the bet on
volatility.
– A speculator would simple enter into the Straddle.
• Long Straddle : Buying a Call and a Put Option at the same

strike price.
Currency Options
Speculating with Currency Options

▪ Speculating with combined put and call options
▪ Straddle - uses both a put option and a call option at the same
exercise price
▪ Good for when speculators expect strong movement in one
direction or the other
▪ Efficiency of the currency options market
▪ Research has found that, when transaction costs are controlled
for, the currency options market is efficient.
▪ It is difficult to predict which strategy will generate abnormal
profits in future periods.
Long Straddle
Payoff
+ Buy Call
(Including Premiums)
St
Buy Put
-
Payoff + Put + Call Premiums
X Straddle
St
-
Short Straddle
Payoff
+
Write Call Write Put
(Including Premiums)
St
Payoff Straddle
+
X St
-
7 International Arbitrage And Interest Rate Parity
Chapter Objectives
 Explain the conditions that will result in various forms

of international arbitrage and the realignments that will
occur in response
 Explain the concept of interest rate parity
 Explain the variation in forward rate premiums across
maturities and over time
Introducing arbitrage
Shleifer and Vishny in the Journal of Finance,
Vol. LII, no. 1 (1997) page 35
“…arbitrage in financial markets requires
no capital and entails no risk…[it involves]
the simultaneous purchase and sale of the
same, or essentially similar, security in two
different markets for advantageously
different prices”
International Arbitrage
Defined as capitalizing on a discrepancy in quoted

prices by making a riskless profit.
Arbitrage will cause prices to realign.
Three forms of arbitrage:
▪ Locational arbitrage
▪ Triangular arbitrage
▪ Covered interest arbitrage
Locational Arbitrage
▪ 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. (See Exhibit 7.1)
▪ Gains from locational arbitrage are based on the amount of
money used and the size of the discrepancy. (See Exhibit 7.2)
▪ Realignment due to locational arbitrage drives prices to
adjust in different locations so as to eliminate discrepancies.
Exhibit 7.2 Locational Arbitrage
Locational Arbitrage (AUD example)
Locational Arbitrage:
exploiting quotation differences between dealers.
Dealer 1 in Australia 100 AUD => 87 USD

(Indirect quote on the USD) Dealer will sell USD at 87
AUD / USD 0.88 / 0.87
Dealer 2 in the US 87 USD => 87/0.86 AUD

(Direct quote on the AUD) => 101.16 AUD
AUD / USD 0.85 / 0.86 Dealer will sell AUD at 86
Triangular Arbitrage
▪ Defined as currency transactions in the spot market to
capitalize on discrepancies in the cross exchange rates between
two currencies. (See Exhibits 7.3, 7.4, & 7.5)
▪ Gains from triangular arbitrage: Currency transactions are
conducted in the spot market to capitalize on the discrepancy in
the cross exchange rate between two countries.
▪ Accounting for the Bid/Ask Spread: Transaction costs
(bid/ask spread) can reduce or even eliminate the gains from
triangular arbitrage.
▪ Realignment due to triangular arbitrage forces exchange
rates back into equilibrium. (See Exhibit 7.6)
Exhibit 7.3 Example of Triangular Arbitrage
Exhibit 7.4 Currency Quotes for a Triangular
Arbitrage Example with Transaction Costs
Exhibit 7.5 Example of Triangular Arbitrage
Accounting for Bid/Ask Spreads
Exhibit 7.6 Impact of Triangular Arbitrage
Triangular Arbitrage (Two directions)
• We should have less than we started with after a round trip.
AUD / USD 0.8842 / 0.8846
AUD / SGD 1.3369 / 1.3377 USD / SGD 1.5051 / 1.5056

Attempt 1:
1 AUD -> 0.8842 USD

-> (0.8842)(1.5051) SGD
-> (0.8842)(1.5051)(1/1.3377) AUD
-> 0.9948 AUD
Attempt 2: What about the other way?

- Check and make sure you find Arbitrage!
Exhibit 7.8 Comparing Arbitrage Strategies
Investment Flows
Current Spot : 0.9883 / 0.9890 CHF / AUD
1 Year Forward : 1.0268 / 1.0291 CHF / AUD
Swiss 1 Year Rate : 2.5%
Australian 1 Year Rate : 6.5%
(Now) Spot
1000 AUD 1011.12 CHF
Invest AUD
Invest CHF
(1 Year)
1065 AUD
Forward
1064.18 AUD 1036.40 CHF
Investment Flows
Current Spot : s0 CHF / AUD Swiss Interest : if
1 Year Forward : f1 CHF / AUD Australian Interest : ih
Let us assume this is a Direct Quote => Unit = FC
Note: We can assume this is an Indirect Quote and
determine an alternative formula if we so wish.
(Now) Spot
1 AUD 1/s0 CHF
Invest AUD
Invest CHF
(1 Year)
1+ih AUD
Forward
F(1+if) / s0 AUD (1+if) / s0 CHF
Theoretical Forward Rate
F (1  i f )
Investment Flows: (1  ih ) 
(Prior slide) S
(1  ih )
Synthetic Forward: F *  (1  i f )
(We will see how to create this
using the Money Market in future weeks) S
S (1  ih )
Theoretical Forward Rate: F * 
(Whether based off Investment Flows (1  i f )
or the use of the Money Market)
Forward Rates are a function of:
 1  i 
home 
Forward  Spot  
1  iforeign 
1. The current spot rate
2. The domestic interest rate
3. The foreign interest rate
If ihome > iforeign....foreign currency is expected to appreciate over
time. (FC ↑ )
If iforeign > ihome…foreign currency is expected to depreciate over
time. (FC ↓ )
Do we use bid or ask quotations?

We should not use the same for both as will become evident
when we see the actual arbitrage cash flows.
Forward Bid or Forward Ask?
Use theoretical forward rate F*
• If F* = F no arbitrage
If F* < > F
=> Possible Arbitrage
F* > F
=> F relatively undervalued
=> Buy Fwd Foreign Currency (Fwd Ask)
F* < F
=> F relatively overvalued
=> Sell Fwd Foreign Currency (Fwd Bid)
Covered Interest Arbitrage

▪ Steps involved in covered interest arbitrage
▪ Defined as the process of capitalizing on the interest rate
differential between two countries while covering your exchange
rate risk with a forward contract.
▪ Consists of two parts: (Exhibit 7.7)
▪ Interest arbitrage: the process of capitalizing on the difference
between interest rates between two countries.
▪ Covered: hedging the position against interest rate risk.
▪ Realignment due to covered interest arbitrage causes market
realignment.
▪ Timing of realignment may require several transactions before
realignment is completed.
Exhibit 7.7 Example of Covered Interest Arbitrage
Covered Interest Arbitrage for fun
and profit (The Signal does not Match)
1 Year Forward : 1.0168 / 1.0191 CHF / AUD [ASSUME]
 1.065 
F * Bid  .9890    1.0276
 1.025 
1.0276 > 1.0168
Fwd Undervalued =>Buy CHF Forward => Forward Ask
=> No Match => Can’t Arbitrage
Covered Interest Arbitrage for fun
and profit (The Signal Matches)
1 Year Forward : 1.0168 / 1.0191 CHF / AUD [ASSUME]
 1.065 
F * Ask  .9883    1.0269
 1.025 
1.0269 > 1.0191
Fwd Undervalued =>Buy CHF Forward => Ask
=> Match => Arbitrage Opportunity
Covered Interest Arbitrage
for fun and profit (The Money)
(Now) Spot (Bid)
Borrow 1000 CHF 988.30 AUD
Invest AUD
To Repay: 1025 CHF
(1 year)
Forward (Ask)
1032.81 CHF 1052.54 AUD
7.81 CHF Profit = 0.781%

Note 1: observe why the Forward Ask was compared to the Spot Bid (Cash flows)
Note 2: this method is net of the opportunity cost. The textbook method of calculating
CIA is a standard return. SEE PAGE 231, paragraph 2. for an explanation.
Rearranging the Expression
S (1  ih )
F
(1  i f ) F (1  ih )
1  1  p
S (1  i f )
F  S (1  ih )  (1  i f )
 p
S (1  i f )
F  S ih  i f
 p
S 1 i f
Theory suggesting that the forward rate differs from the spot
rate by an amount that reflects the interest differential
between two currencies.
When market forces cause interest rates and exchange rates to

adjust such that covered interest arbitrage is no longer feasible,
the result is an equilibrium state known as IRP.
Madura, page 234
Difference in interest Interest Difference between

rates Rate Parity forward and spot rates
iH  iF equals f 0  s0
1  iF s0
In equilibrium, the forward rate differs from the spot rate

by a sufficient amount to offset the interest rate
differential between two currencies.
Derivation of Interest Rate Parity
1  ih
p 1
1 i f
where
p  forward premium
ih  home interest rate
i f  foreign interest rate
Determining the Forward Premium

▪ Effect of the interest rate differential: The relationship
between the forward premium (or discount) and the interest
rate differential according to IRP is simplified in an
approximated form: F S
p  ih  i f
S
where
p  forward premium (or discount)
F  forward rate in dollars
S  spot rate in dollars
ih  home interest rate
i f  foreign interest rate
▪ Implications: If the forward premium is equal to the interest
rate differential as just described, then covered interest
arbitrage will not be feasible.
Exhibit 7.9 Comparing Arbitrage Strategies
Graphic Analysis of Interest Rate Parity (Exhibit 7.9)

▪ Points representing a discount: points A and B
▪ Points representing a premium: points C and D
▪ Points representing IRP: points A, B, C, D
▪ Points below the IRP line: points X and Y
▪ Investors can engage in covered interest arbitrage and earn a
higher return by investing in foreign currency after considering
foreign interest rate and forward premium or discount.
▪ Points above the IRP line: point Z
▪ U.S. investors would achieve a lower return on a foreign
investment than on a domestic one.
How to Test Whether Interest Rate Parity Holds

(Exhibit 7.9)
▪ The location of the points provides an indication of
whether covered interest arbitrage is worthwhile.
▪ For points to the right of the IRP line, investors in the
home country should consider using covered interest
arbitrage, since a return higher than the home interest
rate (ih) is achievable.
▪ Of course, as investors and firms take advantage of
such opportunities, the point will tend to move toward
the IRP line.
▪ Covered interest arbitrage should continue until the
interest rate parity relationship holds.
Interpretation of Interest Rate Parity

▪ Interest rate parity does not imply that investors from
different countries will earn the same returns.
Does Interest Rate Parity Hold?
▪ Compare the forward rate (or discount) with interest rate
quotations occurring at the same time. Due to limitations in
access to data, it is difficult to obtain quotations that reflect
the same point in time.
Considerations When Assessing Interest Rate Parity

▪ Transaction costs
▪ The actual point reflecting the interest rate differential and
forward rate premium must be farther from the IRP line to make
covered interest arbitrage worthwhile. (See Exhibit 7.10)
▪ Political risk
▪ A crisis in the foreign country could cause its government to
restrict any exchange of the local currency for other currencies.
▪ Differential tax laws
▪ Covered interest arbitrage might be feasible when considering
before-tax returns but not necessarily when considering after-tax
returns.
Exhibit 7.10 Potential for Covered Interest Arbitrage
When Considering Transaction Costs
Variation in Forward Premiums
Forward Premiums across Maturities

▪ The annualized interest rate differential between two countries can
vary among debt maturities, and so will the annualized forward
premiums.(See Exhibit 7.11)
Changes in Forward Premiums over Time
▪ Exhibit 7.12 illustrates the relationship between interest rate
differentials and the forward premium over time, when interest rate
parity holds. The forward premium must adjust to existing interest
rate conditions if interest rate parity holds.
▪ Explaining changes in the forward rate
▪ The forward rate is indirectly affected by all the factors that can
affect the spot rate (S) over time, including inflation
differentials, interest rate differentials, etc. The change in the
forward rate can also be due to a change in the premium.
Exhibit 7.11 Quoted Interest Rates for Various
Times to Maturity
50
Exhibit 7.12 Relationship over Time between the
Interest Rate Differential and the Forward Premium
51
Forecasting Foreign Exchange
• Are parity models inconsistent with a random
walk?
• Consistent with the EMH, the spot rate should

incorporate information / expectations.
– Can we beat the market using public information?
Comparison of Arbitrage Effects (Exhibit 7.8)

▪ The threat of locational arbitrage ensures that quoted exchange
rates are similar across banks in different locations.
▪ The threat of triangular arbitrage ensures that cross exchange
rates are properly set.
▪ The threat of covered interest arbitrage ensures that forward
exchange rates are properly set. Any discrepancy will trigger
arbitrage, which should eliminate the discrepancy.
▪ Thus, arbitrage tends to allow for a more orderly foreign
exchange market.
▪ How arbitrage reduces transaction costs
▪ Locational arbitrage limits the differences in a spot exchange rate
quotation across locations, while covered interest arbitrage ensures that
the forward rate is properly priced. Thus, an MNC’s managers should be
able to avoid excessive transaction costs.
SUMMARY
 Locational arbitrage may occur if foreign exchange

quotations differ among banks. The act of locational
arbitrage should force the foreign exchange quotations of
banks to become realigned, after which locational arbitrage
will no longer be possible.
 Triangular arbitrage is related to cross exchange rates. A
cross exchange rate between two currencies is determined
by the values of these two currencies with respect to a third
currency. If the actual cross exchange rate of these two
currencies differs from the rate that should exist, triangular
arbitrage is possible. The act of triangular arbitrage should
force cross exchange rates to become realigned, at which
time triangular arbitrage will no longer be possible.
SUMMARY (Cont.)
 Covered interest arbitrage is based on the relationship between

the forward rate premium and the interest rate differential. The
size of the premium or discount exhibited by the forward rate
of a currency should be about the same as the differential
between the interest rates of the two countries of concern. In
general terms, the forward rate of the foreign currency will
contain a discount (premium) if its interest rate is higher
(lower) than the U.S. interest rate.
 If the forward premium deviates substantially from the interest
rate differential, then covered interest arbitrage is possible. In
this type of arbitrage, a short term investment in some foreign
currency is covered by a forward sale of that foreign currency
in the future. In this manner, the investor is not exposed to
fluctuation in the foreign currency’s value.
SUMMARY (Cont.)
 According to the theory of interest rate parity (IRP), the size of

the forward premium (or discount) should be equal to the
interest rate differential between the two countries of concern.
If IRP holds then covered interest arbitrage is not feasible,
because any interest rate advantage in the foreign country will
be offset by the discount on the forward rate. Thus, covered
interest arbitrage would not generate higher returns than would
be generated by a domestic investment.
SUMMARY (Cont.)
 Since the forward premium of a currency (from a U.S.

perspective) is influenced by the interest rate of that currency
and the U.S. interest rate and since those interest rates change
over time, it follows that the forward premium changes over
time. Thus a forward premium that is large and positive in one
period, when the interest rate of that currency is relatively low,
could become negative (reflecting a discount) if that interest
rate rises above the U.S. level.

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Week 4

Speculation, Arbitrage and

▪ Explain how forward contracts are used to hedge based

• Magnified results: Leverage / Derivatives

Speculation with Currency Futures

Speculating with Currency Call Options

Speculating with Currency Call Options (cont.)

Speculating with Currency Put Options

Example 1 (Spot) Example 2 (Options)

Return = 5.6% Return = 300% (4000-1000) / 1000

Return = 0.7% Return = -50% (500-1000) / 1000

GBP depreciates to 1.36

Return = -4.3% Return = -100% (0-1000) / 1000

Thus when speculating with regards to direction using

(1) Australian speculator’s belief

(2) Australian speculator’s belief

• Long Straddle : Buying a Call and a Put Option at the same

Speculating with Currency Options

Payoff + Put + Call Premiums

 Explain the conditions that will result in various forms

Defined as capitalizing on a discrepancy in quoted

Dealer 1 in Australia 100 AUD => 87 USD

Dealer 2 in the US 87 USD => 87/0.86 AUD

AUD / USD 0.8842 / 0.8846

AUD / SGD 1.3369 / 1.3377 USD / SGD 1.5051 / 1.5056

1 AUD -> 0.8842 USD

Attempt 2: What about the other way?

Do we use bid or ask quotations?

Covered Interest Arbitrage

7.81 CHF Profit = 0.781%

When market forces cause interest rates and exchange rates to

Difference in interest Interest Difference between

In equilibrium, the forward rate differs from the spot rate

Determining the Forward Premium

Graphic Analysis of Interest Rate Parity (Exhibit 7.9)

How to Test Whether Interest Rate Parity Holds

Interpretation of Interest Rate Parity

Considerations When Assessing Interest Rate Parity

Forward Premiums across Maturities

• Consistent with the EMH, the spot rate should

Comparison of Arbitrage Effects (Exhibit 7.8)

 Locational arbitrage may occur if foreign exchange

 Covered interest arbitrage is based on the relationship between

 According to the theory of interest rate parity (IRP), the size of

 Since the forward premium of a currency (from a U.S.

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