Now we all know that forex trading is done through the exchange rate . But the real question is how  exchange rates are derived in real . There are many factors which determine the exchange rate e.g. speculation in the market, Balance of payments, Interest  rate    parity, Inflation  etc etc ….

Before moving on to the theories, let just know the meaning of the Term “Arbitrage”

Arbitrage is an opportunity which creates risk-free return. Arbitrage can  occur due to location differences or due to currency exchanges. Suppose u buy a doll worth Rs.25 in market A which is available in  Rs45 in market B.  what u actually would do …..if you got aware of the situation … ??

Obviously, you will buy the dolls from one market and sell in into the market B. And will make a profit of Rs20 without incurring any loss.  This is called arbitrage opportunity.

Now let’s move on to another aspect, you are not one alone in the market, so soon other will also be aware of this arbitrage opportunity. And they will also do the same thing. Later on , Supply of dolls in the market B will increase , and as a result it’s price will increase and on the contrary, demand of dolls will increase in market A ( as all people are buying dolls from market A to sell into market B) . So by this supply and demand theory the price of dolls will be same in both the  markets. And no one can make profits .this is called arbitrage opportunity is lost.

The same thing also happens with the currency. So people buy loan from one country and invest the same money into another country. And use the arbitrage opportunity. This thing also happens in stock market as well.

Suppose a company named Atlanta  whose NSE Close quote is 56.20  and the same company’s BSE close quote is 51.50 on the same day . So the difference is 4.70 creates an example of arbitrage opportunity.

 The same thing is done with the currency, where one currency falls and price of other currency increases but not as per the theory.let’s read the theory now :-

Interest rate parity :- Interest Rate Parity theory is used to analyze the relationship between  spot rate and  forward rate of currencies.IRP theory says that interest differentials between  two countries will change in such a way that there can be no arbitrage opportunity.

The theory says when Interest of a country increases, the currency price of the country decreases.

Suppose Interest rate in India is 10% and in USA  it’s 6 %. Now a person in USA would want that he should invest in India , so that he can earn more money … right. Where in USA, he will get 1000 @ 6 % so amount will be $ 1060.Suppose Spot rate was  RS45/$ . It will soon become 46.70 after a year so that value of the RS will decrease and all the profit earned upon  interest  will be vanished.

So  if arbitrage opportunity exists in the market , it can’t stay for long. And the market rates will be equal to the parity theory. Otherwise, a person will do nothing but earns a lot of profit by simply depositing the amount from one country to another country.

 So in short if the rate of home currency(rh) doesn’t satisy the above theory’s condition arbitrage opportunity will lie.

Now suppose we just want to calculate how much Interest differentials are there in comparison to one country to another country. We will use the formula of :-

 =  {(rH- rF)/1+rf } 100

The purchase power Parity theory

The samething is done with inflation power. Likewise Interest rate of an country increases, the currency price of the country decreases. Same thing happens with Inflation .

Higher the Inflation rate in country will be offset  by the decrease in the currency.

The formula is still the same. Here we will use inflation rate rather than Interest rates.

Let’s take an example :-

Rf in japan is 6 %and in India it’s 3 %. Spot Rupeeyen is 0.4002and the fwd rate is 0.388874.

Now where u will invest .. ?

Ans :-As IRPT theory prevails , it means that a country’s interest rate benefit will be compensated by the depreciation in the currency of the country.

1. Suppose if the person invest Rs.1lakh in India , he will get 103000.

2. On the other side, if he invest the same in Yen, then he will have to convert it according to the exchange rate so the yen will be 100,000/0.4002 = 249,875

3. Now this amount will be deposited in Japan @ 6 % so the money will be  264,868 yen  after 1 year

4. Now the investor again need the conversion of Yen into the domestic currency means RS.. So  in 264,868 *0.388874 = 103,000

5. So now the profit will be the  difference of the amount earned from the both countries =  Rs(103,000- 103,000 ) = Nil .

Until IRPT  & PPPT  prevails , there will be no arbitrage opportunity.  But if this theory doesn’t work properly, it will create arbitrage . And the person will either  borrow the funds from  other country to invest into his own country or vice-versa.

Regards

Renu