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Arbitrage Without Transaction Cost: Available Capital

- The document discusses arbitrage opportunities between currencies using spot and forward rates with and without transaction costs. - It provides an example of using USD, CHF rates to show that borrowing USD at a lower rate and converting to CHF via forward contract results in savings compared to direct conversion. - Transaction costs are then incorporated, showing the arbitrage profit is reduced by the bid-ask spread amounts.

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Bigbi Kumar
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58 views15 pages

Arbitrage Without Transaction Cost: Available Capital

- The document discusses arbitrage opportunities between currencies using spot and forward rates with and without transaction costs. - It provides an example of using USD, CHF rates to show that borrowing USD at a lower rate and converting to CHF via forward contract results in savings compared to direct conversion. - Transaction costs are then incorporated, showing the arbitrage profit is reduced by the bid-ask spread amounts.

Uploaded by

Bigbi Kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLSX, PDF, TXT or read online on Scribd
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Arbitrage Wit

> Available capital :


> Spot USD/YEN:

> 3 Month USD/YEN Forward rate:


> 3 Month Yen Interest rate =
> 3 Month Dollar Interest rate =

Direct method

>

Invest Yen in the 3 Month deposit @ 8%

>

Value of Investment after Maturity =

1,000,000[1+.25(.08)]
1,020,000

By comparing the Final Investment Value between th


as he makes a profit o

Direct method

> Invest Yen in the 3 Month deposit @ 8%


> Value of Investment after Maturity =

1,000,000[1+.25(.08)]
1,020,000

By comparing the Profits, we can see that the

costs i.e. du

Arbitrage Without Transaction Cost

ailable capital :
ot USD/YEN: 120

1,000,000

Month USD/YEN Forward rate: 121


Month Yen Interest rate =
8%
Month Dollar Interest rate = 12%

Indirect method

000,000[1+.25(.08)]

1) Convert the capital into Dollars using the spot rate & enter in
Forward currency contract.
1,000,000 = $ 8,333.33

1,020,000

2) Invest Dollar in the 3 Month Deposit @ 12%


>

value after maturity = 8,333.33[1+.25(.12)]


=
$8,583.33

3) Convert dollar back to Yen @ 3 Month Forward Rate(i.e USD/Y


$8,583.33 = 1,038,582.93
> Final Invest value is 1,038,582

Investment Value between the two methods, the Investor is better of by taking the Indirect route
as he makes a profit of 18,582.93 over the direct method

Arbitrage with Transaction Cost


>

Available capital :

1,000,000

> Spot USD/YEN: 120/120.5


> 3 Month USD/YEN Forward rate: 121/121.4
> 3 Month Yen Interest rate =
8% - 8.25%
> 3 Month Dollar Interest rate = 12% - 12.35 %

Indirect method

000,000[1+.25(.08)]

1) Convert the capital into Dollars using the spot rate & enter in
Forward currency contract(i.e @121.4).
1,000,000 = $ 8,237.23

1,020,000

2) Invest Dollar in the 3 Month Deposit @ 12%


>

value after maturity = 8,237.23[1+.25(.12)]


=
$8,484.34

3) Convert dollar back to Yen @ 3 Month Forward Rate(i.e USD/Y


$8,484.34 = 1,026,605.14

> Final Invest value is 1,026,605.14


> Profit : 6,605.14
rofits, we can see that the investor is loosing about 11,977.79 due to Transaction

costs i.e. due to the Bid-Ask Spread.

spot rate & enter into 3 Month

33.33[1+.25(.12)]

ward Rate(i.e USD/Yen = 121)

spot rate & enter into 3 Month

37.23[1+.25(.12)]

ward Rate(i.e USD/Yen = 121)

Q) Suppose the USD/AUD spot rate is 2.00 and the 180 day For
Check whether there is a covered interest arbitrage opport

Ans)

>S = 2
>.
_(.)
=2.15
>_$=12%
_=6%
>

According to the Covered Interest Parity theorem

[1+(.5*.12)]/[1+(.5*.06)]
=

Since LHS RHS, Covered Interest Arbitrage Opportunity e

is 2.00 and the 180 day Forward rate is 2.15. The 180-day interest rates are 6% for AUD and 12% fo
d interest arbitrage opportunity.

=6%
(1+_)/(1+_ )= _/

red Interest Parity theorem, we have:

LHS

1+(.5*.12)]/[1+(.5*.06)]
1.02916

RHS
= 2.15/2
= 1.07

est Arbitrage Opportunity exists. Hence an Investor can expect a Higher return by following the ind

are 6% for AUD and 12% for USD.

return by following the indirect route.

Arbitrage Without
> Capital Required:

> Spot USD/CHF: 1.6450


> 6 Month USD/CHF Forward rate: 1.65
USD 6-month interest rate : 4.50%
>
> CHF 6-month interest rate : 6.50%

Direct method

> Convert CHF to USD @ spot rate to pay off the debt.
> Cost to company =

1,000,000*(1.6450)
= CHF 1,645,000

By comparing the Final Cost to company between the t


Indirect route as they save CH

Arbitrage wi
> Capital Required:

> Spot USD/CHF: 1.6450/1.6465

> 6 Month USD/CHF Forward rate: 1.65


USD 6-month interest rate : 4.50%
>
> CHF 6-month interest rate :

Direct method

> Convert CHF to USD @ spot rate to payoff the debt.


> Cost to company =

1,000,000*(1.6450)
= CHF 1,645,000

By comparing the cost to company in both situatio


2500 due to the

bitrage Without Transaction Cost


$1,000,000

HF Forward rate: 1.6580

nterest rate : 4.50%

nterest rate : 6.50%

Indirect method

1) Borrow $1,000,000 @ 4.5% and enter into a 6 Month Forward contract to


repay the loan in CHF.
> At Maturity the company has to repay $ 1,000,000[1+(.045/2)]
= $ 1.0225 million
2) To acquire this in the forward market, it will need:
> CHF (1.0225 x 1.6580)million = CHF 1.695 million

3) Discount this @6.5% to get current cost to company


> Cost to company =

1.695/[1+(0.065/2)]
= CHF 1,641,941.9

Cost to company has reduced by over CHF 3000.


ompany between the two methods, the Company is better of by following the
route as they save CHF 3000 over the direct method

Arbitrage with Trasaction Cost


$1,000,000

1.6450/1.6465

HF Forward rate: 1.6580/1.6590

nterest rate : 4.50%

nterest rate : 6.50% - 6.65%

Indirect method

1) Borrow $1,000,000 @ 4.7% and enter into a 6 Month Forward contract to


repay the loan in CHF.
> At Maturity the company has to repay $ 1,000,000[1+(.047/2)]
= $ 1.0235 million
2) To acquire this in the forward market, it will need:
> CHF (1.0235 x 1.6590)million = CHF 1.698 million

3) Discount this @6.5% to get current cost to company


> Cost to company =

1.6958/[1+(0.065/2)]
= CHF 1,644,552

Cost to company has reduced by CHF 448


any in both situations, we can see that the company looses about CHF
2500 due to the bis-ask spreads.

Month Forward contract to

000[1+(.045/2)]
1.0225 million

1.695 million

Month Forward contract to

000[1+(.047/2)]
1.0235 million

CHF 1.698 million

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