Arbitrages and speculations in international markets

Transcription

1 Arbitrages and speculations in international markets Basic terms: Exchange rates and interest rates quotations Bid/ask spread Arbitrages and speculations Exercise 1 Let s assume the following bid ask quotations for EUR/USD in given interbank markets: bid ask Tokyo London We don t account for any other transaction costs. Answer following questions: If so, what would be your steps you take when exercising a locational arbitrage, if you had 10 million EUR at disposal? What would the process of exchange rate realignment look like? How would the process and result change, if we had 10 million USD? Yes, there is a market discrepancy, because we can sell EUR in Tokyo at bid rate (1.3556) and then purchase in London at ask rate (1.3540). That means selling at the higher price than the purchasing price, which should bring us some profit. It means that our net profit amounts approximately to EUR. If we had 10 million USD, we could convert them into EUR in London and change them back to USD in Tokyo using nominally lower bid quote.

2 It means that our net profit amounts approximately to USD. Exercise 2 Let s assume the following bid ask quotations in international foreign exchange markets: bid ask EUR/CZK USD/CZK EUR/USD We don t account for any other transaction costs. Answer following questions: If so, what would be your steps you take when exercising a triangular arbitrage, if you had 10 million EUR at disposal? What would the process of exchange rate realignment look like? To be able to decide, whether there is a market discrepancy or not, we have to calculate two inequations to see, if one of them is valid. As we start with EUR, we can use either USD or CZK as a third currency. We can sell EUR indirectly (via CZK) at higher price than we could sell it directly. This means that there is a market discrepancy we could capitalize on (selling EUR indirectly and buying it back directly).

3 Our net profit amounts approximately to EUR. The same amount of profit must be reached by using USD as a third currency. Exercise 3 Let s assume following quoted prices: Domestic interest rate 5 % p. a. Foreign interest rate 3 % p. a. Spot rate EUR/USD 3-month forward rate EUR/USD In this case we don t account for bid/ask and deposit/loan spread and USD is our home currency. Answer the following questions: If so, what would be your steps you take when exercising a covered interest arbitrage, if you could borrow 1.5 million USD (1 million EUR respectively)? What would the process of exchange rate realignment look like? (USD is our home currency) What would be the equilibrium forward rate? In this case, we have to compare profitability of domestic and foreign assets. If there is not equation in it, domestic or foreign asset will bring us more profit than the other one. This example is simplified, because we don t account for any spreads. Interpretation is that foreign assets are more profitable to invest in, so we should borrow some funds locally, convert them into foreign currency, then deposit them and immediately convert them back into our home currency using forward market to repay our loan.

4 It means that our net profit amounts approximately to USD. Equilibrium forward rate is EUR/USD. Exercise 4 Let s assume following quoted prices: Domestic interest rate 2 % p. a. Foreign interest rate 4 % p. a. Spot rate EUR/USD 3-month forward rate EUR/USD Over the 3-month horizon we expect USD depreciation up to EUR/USD. What would be our profit from exercising this speculation, if our expectations came true and we could borrow 1 million USD (which is again our home currency)? What would be the result of this speculation if our expectations failed and USD appreciates up to EUR/USD? What would the alternative speculation using forward contract look like? First task spot exchange rate really depreciates to EUR/USD.

5 Second task spot exchange rate appreciates to EUR/USD. Third task our expected future spot exchange rate exceeds forward rate, so we engage in a forward contract to buy foreign currency and then, if our expectation is correct, we will sell foreign currency at higher spot rate. Exercise 5 Let s assume following quoted prices: 3-month domestic deposit rate 2.46 % p. a. 3-month domestic loan rate 2.56 % p. a. 3-month foreign deposit rate 2.63 % p. a. 3-month foreign loan rate 2.69 % p. a. Spot rate EUR/USD (bid quote) EUR/USD (ask quote) 3-month forward rate EUR/USD (bid quote) EUR/USD (ask quote) We don t account for any other transactional cost and USD is our home currency. Answer the following questions: If so, what would be your steps you take when exercising a covered interest arbitrage, if you could borrow 1.5 million USD (1 million EUR respectively)? What would the process of exchange rate realignment look like? What would be the equilibrium forward rate?

6 This example is based on Example 3, but we have to take into account both currency and interest spreads. Interpretation is that domestic assets are more profitable to invest in, so we borrow some funds internationally, convert them into home currency, then deposit them and immediately convert it back into foreign currency using forward market to repay our loan. Our net profit amounts approximately to 1913 EUR and equilibrium forward rate is EUR/USD.