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1. Exchange rate arbitrage
Exchange rate arbitrage is the practice of taking advantage of inconsistent exchange rates in
different markets by selling in one market and simultaneously buying in another. Arbitrageurs do
not take risks or, at least, it is not their intention to do so. In other words, they endeavour to
maintain closed positions at all times. Rates of profit on arbitrage operations are necessarily low in
competitive, well-informed markets, but since transactions are usually very large, absolute profits
may also be large from successful arbitrage. Arbitrage performs the function for a market system of
bringing prices in one market into line with those in other markets.
There are two types of arbitrage of relevance to forex markets: exchange rate arbitrage and
interest rate arbitrage. In exchange rate arbitrage, advantage is taken of differentials in the price of a
currency in different markets. Exchange rate arbitrage transactions may be classified in terms of the
number of markets involved. Thus, we may have two-point and three-point arbitrage.
1.1 Two-point arbitrage
Two-point arbitrage concerns two currencies in two geographically separated markets. For
example, let the spot exchange rate be lb1 = $1.55 in London and lb1 = $1.60 in New York. Here
we are quoting both exchange rates against sterling. That is, we are quoting GBP/USD. This is the
indirect quotation of sterling and the direct quotation of the dollar. Remember that the expression
Currency A/Currency B gives you the amount of Currency B that exchanges for one unit of
currency A. In practice, most exchange rates are quoted against the US dollar. If we were to do
this, we would quote:
In London: USD/GBP lb0.645
In New York: USD/GBP lb0.625.
Thus, in relative terms, sterling is undervalued in London and overvalued in New York.
Provided that capital was free to flow between the two centres, arbitrageurs would attempt to
exploit, and hence profit from, the differential by selling dollars for pounds in London and reselling
the pounds in New York. Assume the arbitrageur sold $1 million in London. For this, he would
have received lb645,161.29. Selling this in New York would have returned him lb1,032,258.06 - a
profit of 5 cents per lb1. The sale of dollars in London would have strengthened sterling and pushed
the value of the pound above $1.55. At the same time, the sale of sterling in New York would have
caused sterling to weaken there, pushing its value below $1.60. The action of arbitrageurs would
bring the rates of exchange in the two centres together.
In practice, the rates wouldn't come exactly into line because of the existence of transactions
costs, but the rates should move to being 'transactions costs close'. There is another simplification
in the above example since no regard is paid to the existence of bid and offer rates of exchange. In
the real world, the rates may have been something like:
London: GBP/USD Bid 1.5495 Offer 1.5505
New York: GBP/USD Bid 1.5995 Offer 1.6005
Selling dollars in London, the arbitrageur would have been quoted the offer rate of 1.5505 and,
thus, would have received lb644,953.24. Buying dollars in New York, the arbitrageur would have
been quoted the bid rate of 1.5995 and would have received lb1,031,602.71. That is, the profits
would have been lower because of the bid-offer spread.
Arbitrage 1 Exchange rate arbitrage.pdf
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