For some reason, I always tend to mess up questions pertaining to this topic. I’m at work right now, and don’t have any examples that I could use, but I was wondering if someone could possibly summarize the different arbitrage strategies under different scenarios (in relation to IRP). Thanks for the help in advance…
is this interest rate parity? way I solve question draw a four-by-four matrix Let’s say Two countries NZ, US US/NZ Spot = .7692 Forward : .7900 Interest rate: NZ: 5% Interest rate: US: 2.5% US NZ Spot Borrow 1000 USD ----> 1000 / .7692 = 1300.05NZD Forward Need to payback 1000*1.025 = 1025 USD in future Now on the NZ side: 1300.05 * 1.05 = 1365.05 NZD Now bring back to US side: 1365.05*.7900 = 1078.39 USD So at the US forward from just borrowing and lending US --\> 1025 is the amount. From moving the NZ and coming around: 1078.39 USD so you have a approx. 53 arbitrage profit. you can try this method with any of the other questions you have. If you started out with some number and at the end you arrived at a -ve arbitrage profit, you basically borrowed the other currency. CP
Do you borrow US, just because the US rates are supposed to go up (given the current rates) relative to NZD rates?
In the books they say if 1+rd < F(1+rf)/S then borrow D
That looks right to me. Thanks a lot for typing that out cpk. It really helps to have some kind of template to work with, when tackling these problems.
no problem… Kevin, I have been seeing many questions, esp in Schweser that relate concept of the rates to the currency, and movement (in economics, Foreign exchange esp.). Could you help clarify those concept? Thanks in advance. CP
schweser states something similar to what cpk pointed out: r(d)-r(f) < (F-S)/S --------- borrow domestic r(d)-r(f) > (F-S)/S --------- borrow foreign
yea…basically easiest way to think about it for me is… you convert the foreign interest rate to domestic terms by multiplying by F/S. now that you are talking apples to apples…you borrow from wherever is cheapest. so as cpk pointed out if 1+rd< f/s *(1+rf) then domestic interest rate is cheaper, and you borrow domestic, and vice versa.
just think about it intuitively… IRP is: F (1+Rd) ___ = _______ S (1+Rf) so, plus in your variables, and see which side is bigger/smaller… then, to get back to equilibrium, the smaller side has to increase, and the larger side has to decrease… so just ask yourself, what transactions need to happen in order to do so… best place to start is, ALWAYS borrow at the cheaper rate…then go from there…