Definition of Arbitrage in case of Forward Market (or Covered Interest Arbitrage)

In the case of forward market, the arbitrage operates on the differential of interest rates and the premium or discount on exchange rates. The rule is that if the interest rate differential is greater than the premium or discount, place the money in the currency that has higher rate of interest or vice-versa. Consider the following examples:

Example

Work out the possibilities of arbitrage gain.

Solution

In this case, it is clear that US $ is at discount on 6-months forward market. The rate of annualized discount is:

Here, the interest rate differential is greater than the discount. So in order to derive to an arbitrage gain, money is to be placed in US$ money market since this currency has a higher rate of interest. The following steps are involved:

Thus, starting from zero one is richer by Canadian $ 2.4 at the end of 6 months period. Accordingly, on borrowings of Canadian $1 million, one will be richer by (100,00,000 x $2.4/1000), i.e., Canadian $ 2400.

Example

Calculate the arbitrage possible from the above data.

Solution

In this case, DM is at a premium against the Can$.

Premium = [(0.67 – 0.665/0.665] x (12/3) x 100 = 3.01 percent Interest rate differential = 9 – 7 = 2 percent.

Since the interest rate differential is smaller than the premium, it will be profitable to place money in Deutsch-marks the currency whose 3-months interest is lower. The following operations are carried out: