Meaning of arbitrage: - It is simultaneous purchase and sale of the same assets or commodities

on different markets to profit from price discrepancies.

Law of one price: - In competitive markets characterized by numerous buyers and sellers, having
low cost access to information exchange adjusted prices of identical tradable goods and financial
assets must be within transition costs of equality worldwide.
International arbitrageurs who follow the principle of Buy low and sell high enforce the
above rule of law of one price.
Forward Premium and Discount: - A foreign currency is said to be at premium if forward rate
expressed is terms of home currency is greater than spot rate or else it is said to be at discount.
Annualized % of forward = FR SR
Premium or Discount
SR

360
.
Forward contract period in days

The following three economic relationships arise due to the prevalence of law or one price and
international arbitraging opportunities.
1. PURCHASE POWER PARITY (PPP)
2. INTEREST RATE PARITY(IRP)
3. INTERNATIONAL FISHER EFFECT (IFE)
PURCHASING POWER PARITY [PPP]
If international arbitrage enforces the law of one price, then the exchange rate between the home
currency and domestic goods must be equal to the exchange rate between home currency and
foreign goods.
In other words, one unit of home currency should have the same purchasing power
worldwide. Ex: - If a pen costs Rs 50 in India and the same model pen costs $1 in US, then
exchange rate shall be $1 = Rs 50.
For same purchasing power to remain constant world wide, the foreign exchange rate
must change approximately the same as difference between the domestic and foreign rates of
inflation.
INTEREST RATE PARITY(IRP)
Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of two
countries remains equal to the differential calculated by using the forward exchange rate and the
spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and foreign
exchange rates. It plays a crucial role in Forex markets.
Covered Interest Differential:
Interest parity ensures that the return on a hedged or covered foreign investment will just
equal the domestic interest rate on investment of identical risk or else it gives rise to covered

interest arbitrage. The process of covered interest arbitrage continues until interest parity holds,
unless there is government interference.

Covered Interest Rate Parity (CIRP)

According to Covered Interest Rate theory, the exchange rate forward premiums (discounts)
nullify the interest rate differentials between two sovereigns. In other words, covered interest rate
theory says that the difference between interest rates in two countries is nullified by the
spot/forward currency premiums so that the investors could not earn an arbitrage profit.
Uncovered Interest Rate Parity (UIP)
Uncovered Interest Rate theory says that the expected appreciation (or depreciation) of a
particular currency is nullified by lower (or higher) interest.