Arbitrage occurs when forward differentials equal the

Arbitrage is the process of selling
and buying identical assets to profit from price variations. There are five important
relationships that result from arbitrage.


Relative purchasing power parity
(PPP) recognises that exchange rates between two countries adjusts to match the
inflation differential. Currencies experiencing higher inflation tend to
depreciate relative to currencies with lower inflation. However, only changes
in real exchange rate influence competiveness between domestic and foreign
firms. PPP doesn’t hold well in the short term since countries have different
price indices and relative prices. It holds better in the long term but ignores
transactional costs.

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The Fisher effect (FE) comprises of
a real required rate and an inflation premium. It recognises that interest rate
(IR) differentials between two countries equals their expected inflation
differential. Currencies experiencing high inflation also receive higher IR. Capital
flows from the currency receiving lower expected real returns to the currency
receiving higher returns to reach equilibrium. Increasing capital market
integration indicates that real returns is established by global demand/supply
rather than local credit.


The International fisher effect (IFE)
combines PPP and FE to emphasise that individuals investing domestically or
abroad should receive an equivalent return. Currencies with lower IR will
appreciate in comparison to currencies with higher IR. This theory holds in the
short and long term. However, it fails to recognise that investing in one
country may carry a greater risk. Consequently, IFE relies on the assumption
that investments are perfect substitutes. IFE is an unbiased predictor of spot
rates thus, changes in IR differentials predicts future spot exchange rate
movements. This IR differential is caused by inflation or real IR changes which
have opposing influences on the spot exchange rate.







Interest rate parity theory (IRP)
indicates that in the absence of transaction costs the forward discount/premium
of a currency is equivalent to the IR differential of the two countries. The forward
premium/discount represents the country with lower/higher IR. The purpose of IRP
is to ensure returns between hedged foreign investment and an identical
domestic investment are equivalent. Consequently, the covered interest
differential equals zero.  If a
difference existed, then covered interest arbitrage can happen until IP is
reached. The IP relationship is strong with minor variations.


Spot and forward rates are based on
expectations of future events and are linked by interest differentials. Movements
experienced in the forward market is felt in the spot market and equilibrium occurs
when forward differentials equal the difference in anticipated exchange rate. The
unbiased forward rate recognises that the forward rate is a representation of
the expected future spot rate. However, market efficiency acknowledges that
risk averse investors require a risk premium for taking on risk. However, currency
risk can be diversifiable indicating no need for a premium. 


Furthermore, currency forecasting
can create constant profits if forecasters have access to a superior model,
regular prior access to information, ability to exploit disequilibrium’s or predict
government intervention. Market-based forecasts use predictions present in the
interest and forward rates. Alternately, Model-based forecasts use fundamental
and technical analysis.