Arbitrage

Interest Arbitrage

In the FX markets, this means that you can make more $$ on te same deposits on teh same bank, but in different currencies.

Triangular Arbitrage

Triangle arbitrage (also known as triangular arbitrage) refers to taking advantage of a state of imbalance between three markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices.

Triangular arbitrage offers a risk-free profit (in theory), so opportunities for triangular arbitrage usually disappear quickly, as many people are looking for them.

Example

Suppose the exchange rate between:

• the Canadian Dollar (CD$) and the US dollar (US$) is CD$1.13/US$1.00 in Canada (1 USD gets you CD$1.13)
• the Australian Dollar (AU$) and the US dollar (US$) is AU$1.33/US$1.00 in Australia (1 USD gets you AU$1.33)
• the Australian Dollar (AU$) and the Canadian Dollar (CD$) is AU$1.18/CD$1.00 (1 CD gets you AU$1.18)

Assuming that a US investor has US$10,000 to invest, he will:

• 1st) Buy Canadian Dollars with his US Dollars: US$10,000 * (CD$1.13/US$1) = CD$11,300
• 2nd) Buy Australian Dollars with his Canadian Dollars: CD$11,300 * (AU$1.18/CD$1.00) = AU$13,334
• 3rd) Buy US Dollars with his Australian Dollars: AU$13,334 / (AU$1.33/US$1.0000) = US$10,025
• 4th) Profit: US$25.00 Risk Free

Note all of this trading could be done in one bank, in one country. For example, and international bank in London might offer investments denominated in all three currencies. So, a smart investor would just approach that one bank, move their money around, and make $25 each time. They could just repeat this process over and over again, and get rich! This is why opportunities like this disappear really, really fast!

Covered interest arbitrage

Example

In this example the investor is based in the United States and assumes the following prices and rates: spot USD/EUR = $1.2000, dollar interest rate = 4.0%, euro interest rate = 2.5%. In this case, the forward exchange rate should show the dollar DEPRECIATE by 1.5%, or else there will be an opportunity. [forward exchange rate] should be = $1.218 (a 1.5% depreciation). But, lets assume that the [forward exchange rate] was different, and was set at forward USD/EUR for 1 year delivery = $1.2300, then the trader could easily make money as follows:

• Exchange USD 1,200,000 into EUR 1,000,000 (todays spot exchange rate of $1.20 / EU)
• Buy EUR 1,000,000 worth of euro-denominated deposits (bonds) at 2.5% (1-year) interest, which guarantees you will have EUR 1,025,000 in 1 year.
• Sell EUR 1,025,000 via a 1 year forward contract. i.e. agree to exchange the euros back into US dollars in 1 year at today's forward price ($1.23 / EU), meaning you will receive USD 1,260,750
• Alternatively, if the USD 1,200,000 were borrowed at 4%, then you would have USD 1,248,000 in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD 12,750 in 1 year.
• This set of transactions can be viewed as having an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1%

Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. Financial models such as interest rate parity and the cost of carry model assume that no such arbitrage profits could exist in equilibrium, thus the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency, for risk-free instruments.

Links:

forward exchange rate

spot exchange rate

foreign currency trading

International Money issues