Interest Rate Parity and Arbitrage

Question 1

Arbitrage is the instantaneous buying and selling of assets to make the profit from a disparity in the price. It is a lucrative business venture since the benefit is gained through the value discrepancy of comparable monetary instruments on diverse markets or different forms. When a person gets into an arbitrage, he or she ensures that the amount of the essential asset purchased and sold should be equal (Du, Tepper & Verdelhan, 2018). The price variation is only indicated as the payoff from the business. The pay-off should be significant enough to cater for the charges engrossed in accomplishing the industry. If not, it should not have any impact on the merchant to start the business. Essentially, arbitrage is a profit endeavor since the main aim of the company is to earn the profit. 

Question 2

There are different strategies that a person can implement to check an arbitrage opportunity. Basically, the opportunity lies in the market setup that has particular incompetence. Someone can get such changes to make safe profits in many markets. In David’s case, there is an arbitrage opportunity whereby, he has made a lot of investments in the foreign stocks and government bonds. Checking the arbitrage opportunity depends on his strategy to ensure that buying and selling international shares are profitable for the business (Pinnington & Shamloo, 2016). Also, he has to establish risk-free arbitrage where the provisional difference is honored to get income. Such arbitrages include stock and assets that she already has.

The formula For Interest Rate Parity (IRP) is

F0 is the forward rate.

S0 is the spot rate.

ic is the interest rate in country  c.

ib is the interest rate in country  b

Question 3

The best strategy that David can use to know which currency to borrow is by evaluating the money whose nation has a lower interest rate than the other. In such a situation, the currency is referred to as the funding currency. Also, he can choose to invest in a country that has a higher interest rate, and the money is referred to as the asset cash. In such a scenario, he needs to calculate the involved interest of in the investment currency compared with the market price. In most instances, dollars have a higher interest rate compared to the euro (Mele et al., 2017). However, it also depends with the nation that he intends to invest or the business to establish with such amount. In general, the best way to decide which currency to borrow is by creating the interest rate and the investment he is going to institute. 

Assuming that the EUR/USD exchange rate is 1.20 and he would like to exchange $100 U.S. dollars into  Euros . To complete this, he can just divide the $100 by 1.20. What he gets is the amount of Euros that he will get and it is 83.33 changing Euros to U.S. dollars requires overturning that procedure by multiplying the number of Euros by 1.20 to get the figure of U.S. dollars.  

For instance,

1,200,000*(1+i$) = (1,000,000/S($/€))*(1+ i€)*F($/€)

(1.2+i$) = (1/S($/€))*(1+ i€)*F($/€) 

Following the rearrangement of terms in the above equation, we can find the IRP (i.e. Interest Rate Parity) equation between the dollar and the euro: 

F($/€) / S($/€) = (1.2+i$) / (1+i€)

Therefore, there is an arbitrary opportunity since the value of the dollar surpasses the values of the euro and borrowing the money would yield profit.

Question 4

If David borrows the wrong currency, he will undergo a lot of losses since the lenders may not understand the situation. For instance, if he chooses to acquire in a foreign currency, there are always precautions. The significant risk of borrowing in a foreign currency is that when someone is paying the loan back, he or she has to pay using the same foreign currency. Also, even if the investments do not year any profit, the money still has to be returned with the accrued interest (Mancini-Griffoli & Ranaldo, 2011). Also, it means that he will incur all the losses and pay back the money. Therefore, it is always critical to make informed decisions when borrowing to avoid getting the wrong currency.

Question 5

Hedging his bets is among the best strategies David can implement to make money and protect himself from the foreign-currency risk. He is an average investor he won’t lose any currency in case the investment falls. However, there is also a risk such that the currency appreciates; he won’t gain anything (Lothian, & Wu, 2011). Such a situation can protect him against the fall in the currency, and he can make money comfortably.

Short an overvalued currency is another way that David can use to make money. As such, he can use the borrowed money for short term investment and return the money within a short period (Pinnington & Shamloo, 2016). Investors can use such an approach to invest in the currency for a fixed price on a particular date.

Also, David can look for high-interest rates and exchange the money to gain more. Either, if he chooses the euro, he can search for a better option to sell the amount or invest in a place where the euro has high value. Also, if he chooses dollar, he can still look for areas where the cost is high and sell or invest in such trade. 

Question 6

There are different risks that he has to undertake when following the steps mentioned above. For instance, there are sometimes when the value of the currency goes down yet he borrowed at a higher rate. Therefore, he should be psychologically prepared for the loss.

Question 7

In most instances, the profit depends on the investment he is going to make. Therefore, there is no stipulated amount of the profit that he is going to make after following the identified steps. 

Question 8

The best strategies to implement if he borrows the other currency are to ensure that the interest rate is lower than the initial amount. In such a situation, he will be able to make more profits from the investments as compared to the preliminary amount. Notably, the profit and the loss will also depend on how he will invest his money.

References

Du, W., Tepper, A., & Verdelhan, A. (2018). Deviations from covered interest rate parity.  The Journal of Finance ,  73 (3), 915-957.

Lothian, J. R., & Wu, L. (2011). Uncovered interest-rate parity over the past two centuries.  Journal of International Money and Finance ,  30 (3), 448-473.

Mancini-Griffoli, T., & Ranaldo, A. (2011). Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity.

Mele, M., Quarto, A., MohdSanusi, Z., MotjabaNia, S., Roosle, N. A., Nelly, R., ... & Olanipekun, I. O. (2017) International Journal Of Economics And Financial Issues.  Balance Sheet ,  56 , 67.

Pinnington, J., & Shamloo, M. (2016).  Limits to arbitrage and deviations from covered interest rate parity  (No. 2016-4). Bank of Canada staff discussion paper.