Covered Interest arbitrage
If the (Forward rate (d/f) / spot rate (d/f)) = ((1+domestic interest rate)^t / (1+foreign interest rate)^t then no arbitrgae position exists. However if they do not equal, then there is an arbitrage position.
To determine how to trade on this, take an agnostic view and determine what could happen to make it an inequality. For example if LHS < RHS, then domestic interest rate could fall, foreign interest rate could rise, spot rate could fall, or forward rate could rise. Plan your trade accoringly.
Since foreign rate is too low (and hence could rise), borrow in that country. Since spot rate could fall, convert now (before the fall), since domestic rate is too high, invest there now, and finally since the forward rate could rise, agree to convert now.
Example:
Triangular arbitrage
S (a/b) * S(b/c) * S(c/a) must equal 1.0
if not, an arbitrage position exists.
- if <1, buy the currency in the denominator, sell the currency in the numerator.
- if >1, sell the currency in the denominator, buy the currency in the numerator.
Example:
In the above parity conditions, the various contracts are sold, so the parity conditions hold quite well. Other parity conditions hold less well:
Relative Purchase Power Parity
Forward Parity
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