International Arbitrage

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Meaning of International Arbitrage

International Arbitrage is the process of selling and buying the foreign securities and ADRs simultaneously for taking advantage of imperfect pricing of different international markets.

Arbitrage is the process of selling and buying the same assets or commodity simultaneously for taking advantage of imperfect pricing of markets. An arbitrager buys the security from one market at lower price and sell the same security at higher price in another market for taking riskless advantage.

However, if market is in equilibrium then there is no any space for arbitrage. Therefore, for arbitrage there must be a price mismatch for the same asset in the market.

Types of International Arbitrage

International Arbitrage can be further divided into components as mentioned below-

Types of International Arbitrage
Covered Interest Arbitrage (CIA)

This is the first international arbitrage. Under CIA arbitrageur takes the advantage of interest rate differential between two countries by hedging himself under forward contract to earn riskless profit.

The term ‘Covered’ means hedging through forward contract in forex market against fluctuation in exchange rate and the term ‘Interest Arbitrage’ means taking advantage of interest differential between two countries.

This international arbitrage is possible only when Interest Rate Parity (IRP) is not valid. That means interest differential is not equal to percentage of spread between two currencies.

Now let’s understand this international arbitrage in simple words. Under this international arbitrage there would be two scenario and our action would be based on under or overpricing of base currency.

Scenario I – Base Currency Overpriced in Forex Market

  • To take benefit of overpricing, an arbitrager will sell (short position) base currency in Forex Market
  • In this case to cover above position an arbitrager has to deposit (long position) base currency in Money Market.
  • To deposit the base currency, he has to borrow in price currency in Money Market and convert the borrowed price currency in base currency for deposit.

Scenario II – Base Currency Under-priced in Forex Market

  • To take benefit of under-pricing, an arbitrager will buy (long position) base currency in Forex Market
  • In this case to cover above position an arbitrager has to borrow (long position) base currency in Money Market.
  • After borrowing in base currency, he will deposit in price currency in Money Market by converting the borrowed base currency in price currency.

If you want to see example and other discussion about this international arbitrage then click here

Two Point Arbitrage

Second type of International Arbitrage is Two Point Arbitrage. Buying a currency in one market and selling it at higher price in another geographically different market is called two-point arbitrage.

Normally exchange rate for a given currency should be same in every part of the world. However, due to some discrepancies in the market the prices might be differ in various markets and in such case, arbitrageur would buy the currency in the market where its price is lower and then sell the currency in the market where its price is higher.

If the exchange rate differential is higher than the transaction cost, an arbitrage profit can be made.

Do Remember:

What would be no arbitrage condition for two currencies?

  • Bid rate of one bank = ask rate of another bank
  • Ask rate of one bank is above bid rate of another bank

If you want to see example and other discussion about this international arbitrage then click here

Triangular Arbitrage or Three Point Arbitrage

This is the third one under the International Arbitrage category. Triangular Arbitrage is the result of mis-match of exchange rate of three currencies. Under this international arbitrage mechanism arbitrageur takes advantage of discrepancy among three different currencies in the foreign exchange market. Triangular arbitrage may exist only when derived or implied cross rate is not equal to quoted exchange rate.

Suppose there are three currency i.e. ‘A’, ‘B’ and ‘C’ then under this international arbitrage, if there is any arbitrage opportunity, the arbitrageur will sell currency ‘A’ and buy currency ‘B’, then sell currency ‘B’ and buy currency ‘C’ and then sell currency ‘C’ and buy currency ‘A’. It means triangular arbitrage involve three trade that’s why it is known as triangular arbitrage.

Calculation Step for this international arbitrage

  1. Calculate implied or derived cross rate
  2. Compare implied cross rate with quoted exchange rate and select higher bid and lower ask
  3. Calculate profit which is difference of above selected rates
  4. Then start triangular arbitrage by selling that currency which is reported in profit.
  5. Sell 1 unit of ‘A’ and buy ‘B’ * Sell 1 unit of ‘B’ and buy ‘C’ * Sell 1 unit of ‘C’ and buy ‘A’ = ****** ( – ) Initial Investment 1 = Profit

If you want to see example and other discussion about this international Arbitrage then click here


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