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Lecture International finance: An analytical approach (3/e): Chapter 11 - Imad A. Moosa

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Chapter 11 - International arbitrage. In this chapter, the learning objectives are: To define arbitrage and the no-arbitrage condition; to describe two-point, three-point and multi-point arbitrage in the foreign exchange market; to describe commodity arbitrage;…

Chapter 11 International Arbitrage Objectives • To define arbitrage and the no-arbitrage condition • To describe two-point, three-point and multi-point arbitrage in the foreign exchange market • To describe commodity arbitrage (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-2 Objectives (cont.) • To describe covered interest arbitrage and show how the no-arbitrage condition can be used to determine the forward exchange rate • To describe uncovered arbitrage and introduce the concept of carry trade Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-3 Definition of arbitrage • Arbitrage is generally defined as capitalising on a discrepancy in quoted prices as a result of the violation of an equilibrium (no-arbitrage) condition • The arbitrage process restores equilibrium via changes in the supply of and demand for the underlying commodity, asset or currency (cont.) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-4 Definition of arbitrage (cont.) • The importance of arbitrage is that no-arbitrage conditions are used for asset pricing, such that the equilibrium price of a financial asset is the price that is consistent with the underlying no-arbitrage condition Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-5 Two-point arbitrage • Also known as spatial or locational arbitrage, it arises when the following condition is violated: S A ( x / y) SB ( x / y) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-6 Two-point arbitrage with bid-offer spreads • With bid-offer spreads the no-arbitrage condition becomes: Sb , A x / y Sa, B x / y Sa, A x / y Sb , B x / y Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-7 Three-point (triangular) arbitrage • It is triggered when cross exchange rates are inconsistent, that is, when the following condition is violated: S ( x / z) S ( x / y) S ( y / z) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-8 Profitable/unprofitable sequences (b) Profitable sequence (a) Unprofitable sequence x x S ( x / y) z S ( x / z) S ( y / z) y z Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa y 11-9 Multipoint arbitrage • The condition precluding multipoint arbitrage is: S ( x1 / x2 ) S ( x2 / x3 ) S ( xn / x1 ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-10 Covered interest arbitrage • Covered interest arbitrage is triggered by the violation of the covered interest parity (CIP) condition, which describes the equilibrium relation between the spot exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-14 Return on Investments Investor (K) Foreign investment Converting at  spot rate Domestic investment K S    Investing in  foreign assets K    (1 i ) S Reconverting at  forward rate KF (1 i ) S K (1 i ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-15 The CIP equilibrium condition F (1 i ) (1 i ) S i i f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-16 Covered interest arbitrage Foreign   domestic Domestic   foreign Borrowing  domestic currency Converting at  spot rate Investing at  foreign rate 1 unit   1 unit   1 unit   Converting at  spot rate    S S     S Loan  repayment Loan  repayment (1 i ) S Reconverting at  forward rate Borrowing  foreign currency F (1 i ) S Investing at  domestic rate S   (1 i )    i i S (  1 i ) F Covered margin Covered margin F (1 i ) S S (1 i ) F (1 i ) Reconverting  at forward rate (1 i ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-17 Profit from covered arbitrage (domestic→foreign) π F (1 i ) (1 i ) S π i i f Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-18 The interest parity forward rate F i S i Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-19 Covered arbitrage with bid-offer spreads (domestic→foreign) π Fb (1 ib ) (1 ia ) Sa π ib ia f m Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-20 Covered arbitrage with bid-offer spreads (foreign→domestic) π Sb (1 ib ) (1 ia ) Fa π ib ia f m Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-21 Arbitrage with bid-offer spreads Foreign   domestic Domestic   foreign Borrowing  domestic currency Converting at  spot offer rate Investing at  foreign bid rate Reconverting at  forward bid rate 1 unit   1 unit   1 unit   Borrowing  foreign currency Converting at  spot bid rate    Sa Sb   S Loan  repayment Loan  repayment (1 ib ) Sa Fb (1 ib ) Sa Sb   (1 ib )    ia Covered margin Fb (1 ib ) Sa Investing at  domestic bid rate (1 ia ) ia Sb   (1 ib ) Fa Reconverting at  forward offer rate Covered margin Sb (1 ib ) Fa (1 ia ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-22 Uncovered interest arbitrage • Uncovered arbitrage is triggered by the violation of the uncovered interest parity (UIP) condition It is described as ‘uncovered’ because, unlike covered arbitrage, the long currency position is not covered in the forward market but rather left uncovered or open Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-23 Carry trade • Carry trade is a kind of uncovered interest arbitrage in which a short position is taken on a low-interest currency and a long position is taken on a highinterest currency Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-24 Return on domestic investment and foreign investment (with uncovered position) Investor (K) Foreign Investment Converting at  spot rate Domestic Investment K S    Investing in  foreign assets K (1 i ) S Reconverting at     expected spot rate KS e (1 i ) S K (1 i ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-25 The UIP condition i i i Se (1 i ) S S e Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-26 Uncovered interest arbitrage Foreign   domestic Domestic   foreign Borrowing  domestic currency Converting at  spot rate Investing at  foreign rate 1 unit      S0 1 unit   1 unit   Converting at  spot rate S0   S Loan  repayment Loan  repayment (1 i ) S0 Reconverting at  spot rate Borrowing  foreign currency S1 (1 i ) S0 Investing at  domestic rate S0  (1 i )    i i S0 (1 i ) S1    Covered margin Covered margin S1 (1 i ) S0 S0 (1 i ) S1 (1 i ) Reconverting  at spot rate (1 i ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-27 Uncovered arbitrage with bid-offer spreads Foreign   domestic Domestic   foreign Borrowing  domestic currency Converting at  spot offer rate Investing at  foreign bid rate Reconverting at  spot bid rate 1 unit   Borrowing  foreign currency 1 unit   1 unit   Converting at  spot bid rate    Sa Sb   S Loan  repayment Loan  repayment (1 ib ) Sa Sb1 (1 ib ) Sa Sb 0  (1 ib )    ia Covered margin Sb1 (1 ib ) Sa Investing at  domestic bid rate (1 ia ) ia Sb   (1 ib ) S a1 Reconverting at  spot offer rate Covered margin Sb (1 ib ) S a1 (1 ia ) Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 11-28 ... McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 1- 6 Two-point arbitrage with bid-offer spreads • With bid-offer... Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 1- 11 Commodity arbitrage • The no-arbitrage condition... condition Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 3e by Imad A Moosa Slides prepared by Afaf Moosa 1 1- 5 Two-point arbitrage • Also known

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