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Understanding Currency Arbitrage and Interest Rate Differences

Discover the concepts of exchange arbitrage and interest arbitrage, two crucial strategies in foreign exchange markets. Exchange arbitrage involves profiting from differences in currency rates across various locations, ensuring consistent rates and relationships. On the other hand, interest arbitrage takes advantage of varying short-term interest rates on comparable assets in different currencies. Learn about forward foreign exchange contracts, forward exchange value versus spot exchange value, and the covered interest parity condition to enhance your understanding of these trading strategies.

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Understanding Currency Arbitrage and Interest Rate Differences

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  1. Exchange Arbitrage Exchange arbitrage, the process of buying and selling currencies to make a profit, ensures that rates in different locations are essentially the same, and rates and cross-rates are related and consistent among themselves.

  2. Interest Arbitrage The process by which individuals seek to make a profit by taking advantage of differences in short-term interest rates available on comparable assets denominated in different currencies at a given point in time.

  3. Forward Foreign Exchange Contract A forward foreign exchange contract is an agreement to exchange one currency for another on some date in the future at a price set now (forward exchange rate).

  4. Forward Exchange Value ( fxv) Vs. Spot Exchange Value (sxv) • If fxv > sxv: Forward Premium; • If fxv < sxv: Forward Discount; • If fxv = sxv: Flat (even)

  5. In the following examples, is the dollar selling at a premium or discount? • eS : $/£ = 1.77 eF : $/£ = 1.78 • $/¥ = 0.004 $/¥ = 0.005 • $/DM = 0.40 DM/$ = 2.50 • FF/$ = 6.06 $/FF = 0.15 • $/SF = 0.51 SF/$ = 1.94

  6. Interest Arbitrage The process by which individuals seek to make a profit by taking advantage of differences in short-term interest rates available on comparable assets denominated in different currencies at a given point in time.

  7. Covered Interest Parity Condition The forward exchange value of a currency tends to exceed its spot value by the same percentage as its interest rates are lower than foreign interest rates. ( iU.S.- iU.K.) = ( eF - eS) / eS

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