ARBITRAGE OPPURTUNITY

IN FOREIGN EXCHANGE MARKETS

Definition

Arbitrage traditionally has been defined as the purchase of assets or

commodities on one market for immediate resale on another in order to profit
from a price discrepancy.

Arbitrage is the practice of taking advantage of a price difference between two

or more markets: striking a combination of matching deals that capitalize upon
the imbalance, the profit being the difference between the market prices.

The purchase of currencies on one market for immediate resale on another in

order to profit from the exchange rate differential is known as currency
arbitrage.

Arbitration

Arbitrage opportunities may exist across different markets and/or across assets
that can be designed to be perfect substitutes. Sometimes companies deal in
foreign exchange to make a profit.

Arbitrage can also be referred as the purchase of foreign currency on one market
for immediate resale on another market; it is an operation that consists in
deriving a profit without risk from a differential existing between different quoted
rates. It may result from two currencies or more. The purchase and sale of a
foreign currency in different centers to take advantage of the rate differential is
known as ‘arbitrage operations’.

Arbitrage in the foreign exchange market can be done in several ways: the most
basic form is the inter-bank arbitrage, which exploits differences in banks’ prices
in the same market. It consists of buying a currency from one bank at its low rate
and simultaneously selling to another bank at its high rate. Covered interest rate
arbitrage consists of simultaneous transactions in the spot and forward markets
for foreign exchange and domestic and foreign securities. An arbitrageur
searches for possibilities of an instantaneous and riskless profit from an
appropriate combination of transactions.

Foreign Exchange Market

  

The computerized communication network that embraces all the major financial
centers of the world is the main trait of the foreign exchange market, where the
buyers and sellers of any country can trade currency quickly and efficiently. 
The main players in the foreign exchange market are large banks, governments,
central banks, multinational corporations, and currency speculators. Individuals
investing in the international currency market constitute a small fraction of the
market. Huge trading volume, extreme liquidity, and round the clock trading
hours set the foreign exchange market apart from all other kinds of financial
markets. 

The exchange rate of a currency in the foreign exchange market depends on

various factors. Some of the major factors that affect the exchange rate are:
economic factors, political conditions of the corresponding countries, and market
psychology. The monetary value of a currency is another major determinant of
the exchange rate. 

The foreign exchange market (currency market or forex market) is a worldwide

decentralized over-the-counter financial market for the trading of currencies.
Financial centers around the world function as anchors of trading between a wide
range of different types of buyers and sellers around the clock, with the exception
of weekends. The foreign exchange market determines the relative values of
different currencies. The primary purpose of the foreign exchange market is to
assist international trade and investment, by allowing businesses to convert one
currency to another currency.

Market Makers
Unlike a stock market, the foreign exchange market is divided into levels of
access. At the top is the inter-bank market, which is made up of the
largest commercial banks and securities dealers. Within the inter-bank market,
spreads, which are the difference between the bid and ask prices, are razor
sharp and usually unavailable, and not known to players outside the inner circle.
The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips
for some currencies such as the EUR). This is due to volume. If a trader can
guarantee large numbers of transactions for large amounts, they can demand a
smaller difference between the bid and ask price, which is referred to as a better
spread. The levels of access that make up the foreign exchange market are
determined by the size of the "line" (the amount of money with which they are
trading).

The top-tier inter-bank market accounts for 53% of all transactions. After that

there are usually smaller banks, followed by large multi-national corporations
(which need to hedge risk and pay employees in different countries), large hedge
funds, and even some of the retail FX-metal market makers. According to Galati
and Melvin, “Pension funds, insurance companies, mutual funds, and other
institutional investors have played an increasingly important role in financial
markets in general, and in FX markets in particular.
Exchange Rates Controllers

 Fixed Exchange Rates

 Other Exchange Rate Systems
– Freely Floating
– Managed Float or Dirty Float Policy
– Pegged Exchange Rate System
 Balance of Payments

Features of Arbitration

 Exchange work 
Due to the different geographical position of the various financial centre,
the Asian market, the European market, the Americas market because of
the time difference relations, it has become an entire day 24 hour
continued operation whole world foreign exchange market.

 It consists market but no trading field 

The finance industry in the western countries consist two sets of systems,
namely the centralism business central operation and there is no fixed
place for such business network. Stock trading is being traded through
stock exchange. Like the New York Stock Exchange, the London stock
market, the Tokyo stock market, respectively is American, English, the
Japanese stock main transaction place, it is a centralism business
financial commodity, its quoted price, the transaction time and hand over
to the procedure all consist of unification the stipulation, and has
established the same business association, it has formulated the same
business rules. The investor could buy and sells the commodity through
the broker company, this is known as "consist of trading market and
trading field".
  Zero and Game
In the stock market, the rise or the drop of stock market could influence
the value of the stock whether to rise or drop, for example the Japanese
new date iron stock price falls from 800 Japanese Yen to 400 Japanese
Yen, the value of this stock has been reduced to half.

Types of Arbitration

This part explores two of these relationships and associated arbitrage

opportunities:

 Cross-Rate Arbitrage
 Geographical Arbitrage

Cross-Rate Arbitrage

Cross-rate arbitrage, if present, allows you to exploit misalignments in cross

rates. A cross-rate is the exchange rate between two currencies that is implied by
the exchange on other currencies.

Example:

In New York, there is a rate quoted for the U.S. dollar versus the euro. There is
also a rate quoted for the U.S. dollar versus the British pound. Together these
two rates imply a rate

Geographical Arbitrage

Geographical arbitrage occurs when one currency sells for a different prices in
two different markets.
Interest Market

Money from all over the world is bought, sold and traded. On the Forex, anyone
can buy and sell currency and with possibly come out ahead in the end. When
dealing with the foreign currency exchange, it is possible to buy the currency of
one country, sell it and make a profit. For example, a broker might buy a Italian
lira when the lira to dollar ratio increases, then sell the liras and buy back
American dollars for a profit.

The foreign exchange market, sometimes known as the Forex market, is one that
is affected by several things. The market itself is becoming one of the most
popular forms of trading today. It once was reserved for the richest of the rich,
however today with lower minimums; this is a market that draws people from all
financial levels. The attractive thing about this market is both its leverage and it
liquidity. Many people with a grand background in the Forex system can take
very little money and turn it into a lot using the foreign exchange market.
However, when you have expertise in the foreign exchange market, you must
also be aware of things that affect it. Being aware of these things is part of
making logical and rational decisions of trading. 

Interest rates are something that drives the foreign exchange market. While
currency prices are what the market is all about, interest rates have a direct
affect on those prices. Therefore, to be able to understand the current foreign
exchange market, one must understand the current conditions of each individual
interest rate. While economic and political conditions are also among the things
that greatly affect the Forex, there is nothing that affects it more than interest
rates. Something to remember is that money often follows interest rates. When
the interest rates raise, investors will want to capitalize high returns and you will
see money flowing into the country. When one country's interest rates rise, their
currency is seen as being stronger than other currencies. This happens because
investors seek more of that currency to profit more. Otherwise, it is seen as a
good thing when interest rates rise and a bad thing when they fall. 
Reasons For Interest Rate Change

 Political short-term gain:

Lowering interest rates can give the economy a short-run boost. Under
normal conditions, most economists think a cut in interest rates will only
give a short term gain in economic activity that will soon be offset by
inflation. The quick boost can influence elections. Most economists
advocate independent central banks to limit the influence of politics on
interest rates.

 Inflationary expectations:
Most economies generally exhibit inflation, meaning a given amount of
money buys fewer goods in the future than it will now. The borrower needs
to compensate the lender for this.

 Alternative investments:
The lender has a choice between using his money in different
investments. If he chooses one, he forgoes the returns from all the others.
Different investments effectively compete for funds.

 Liquidity preference:
People prefer to have their resources available in a form that can
immediately be exchanged, rather than a form that takes time or money to
realise.

 Taxes:
Because some of the gains from interest may be subject to taxes, the
lender may insist on a higher rate to make up for this loss.