Foreign exchange arbitrage exploits currency price differences across markets. It's a quick, large-volume strategy that takes advantage of market inefficiencies to generate risk-free profits. These opportunities are typically short-lived due to market efficiency.

Interest rate parity (IRP) links interest rates and exchange rates between currencies. It plays a crucial role in exchange rate determination, maintaining equilibrium in forex markets. IRP suggests that currencies with higher interest rates tend to depreciate, guiding investor decisions in international markets.

Arbitrage and Interest Rate Parity

Concept of foreign exchange arbitrage

• Arbitrage definition encompasses simultaneous buying and selling of assets in different markets exploiting price discrepancies to generate risk-free profits
• Foreign exchange arbitrage takes advantage of currency price differences across markets through various methods (triangular arbitrage, covered interest arbitrage)
• Characteristics of arbitrage opportunities include short-lived nature due to market efficiency, require quick execution, often involve large transaction volumes

Interest rate parity in exchange rates

• Interest rate parity (IRP) establishes relationship between interest rates and exchange rates of two currencies
• Types of IRP include covered interest rate parity (CIRP) and uncovered interest rate parity (UIRP)
• Key components of IRP involve spot exchange rate, forward exchange rate, domestic interest rate, foreign interest rate
• IRP plays crucial role in exchange rate determination by maintaining equilibrium condition in foreign exchange markets and preventing arbitrage opportunities between currencies
• IRP implications suggest currency with higher interest rate tends to depreciate and guides investor decisions in international markets

Covered interest rate parity formula

• CIRP formula expressed as $F/S = (1 + i_d) / (1 + i_f)$ where F: Forward exchange rate, S: Spot exchange rate, $i_d$: Domestic interest rate, $i_f$: Foreign interest rate
• Steps to identify arbitrage opportunities:
  1. Calculate implied forward rate using CIRP
  2. Compare with actual forward rate in market
  3. Determine if profitable opportunity exists
• Arbitrage strategy implementation involves:
  1. Borrowing in low-interest currency
  2. Converting to high-interest currency
  3. Investing at higher rate
  4. Using forward contract to hedge exchange rate risk

Market inefficiencies vs arbitrage opportunities

• Market inefficiencies arise from information asymmetry, delayed price adjustments, regulatory constraints
• Transaction costs include bid-ask spreads, brokerage fees, bank charges
• Impact on arbitrage profitability reduces potential gains, creates "neutral band" where arbitrage not profitable
• Factors affecting persistence of arbitrage opportunities include market liquidity, trading volume, technological advancements in trading systems
• Risk considerations encompass execution risk, counterparty risk, operational risk
• Limits to arbitrage involve capital constraints, short-selling restrictions, regulatory barriers