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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.
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
central banks. The exchange rate of a currency in the foreign exchange market depends on various factors. multinational corporations. Covered interest rate arbitrage consists of simultaneous transactions in the spot and forward markets for foreign exchange and domestic and foreign securities. 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. Some of the major factors that affect the exchange rate are: economic factors. and currency speculators. governments. and market . The main players in the foreign exchange market are large banks. It consists of buying a currency from one bank at its low rate and simultaneously selling to another bank at its high rate. An arbitrageur searches for possibilities of an instantaneous and riskless profit from an appropriate combination of transactions. and round the clock trading hours set the foreign exchange market apart from all other kinds of financial markets.foreign currency in different centers to take advantage of the rate differential is known as µarbitrage operations¶. which exploits differences in banks¶ prices in the same market. extreme liquidity. political conditions of the corresponding countries. Huge trading volume. Individuals investing in the international currency market constitute a small fraction of the market. Arbitrage in the foreign exchange market can be done in several ways: the most basic form is the inter-bank arbitrage. where the buyers and sellers of any country can trade currency quickly and efficiently.
Market Makers Unlike a stock market. The foreign exchange market determines the relative values of different currencies. The monetary value of a currency is another major determinant of the exchange rate. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock. This is due to volume. At the top is the inter-bank market. which is referred to as a better spread. which is made up of the largest commercial banks and securities dealers. The primary purpose of the foreign exchange market is to assist international trade and investment. insurance companies. with the exception of weekends. According to Galati and Melvin. 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).psychology. and even some of the retail FX-metal market makers. If a trader can guarantee large numbers of transactions for large amounts. large hedge funds. The top-tier inter-bank market accounts for 53% of all transactions. spreads. and not known to players outside the inner circle. . Within the inter-bank market. the foreign exchange market is divided into levels of access. After that there are usually smaller banks. and in FX markets in particular. they can demand a smaller difference between the bid and ask price. by allowing businesses to convert one currency to another currency. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). which are the difference between the bid and ask prices. mutual funds. and other institutional investors have played an increasingly important role in financial markets in general. followed by large multi-national corporations (which need to hedge risk and pay employees in different countries). ³Pension funds. are razor sharp and usually unavailable. The foreign exchange market (currency market or forex market) is a worldwide decentralized over-the-counter financial market for the trading of currencies.
y It consists market but no trading field The finance industry in the western countries consist two sets of systems.Exchange Rates Controllers y y Fixed Exchange Rates Other Exchange Rate Systems ± ± ± y Freely Floating Managed Float or Dirty Float Policy Pegged Exchange Rate System Balance of Payments Features of Arbitration y Exchange work Due to the different geographical position of the various financial centre. this is known as "consist of trading market and trading field". the transaction time and hand over to the procedure all consist of unification the stipulation. the Asian market. English. . Like the New York Stock Exchange. the Japanese stock main transaction place. its quoted price. it is a centralism business financial commodity. namely the centralism business central operation and there is no fixed place for such business network. the Americas market because of the time difference relations. Stock trading is being traded through stock exchange. and has established the same business association. the Tokyo stock market. The investor could buy and sells the commodity through the broker company. it has formulated the same business rules. it has become an entire day 24 hour continued operation whole world foreign exchange market. respectively is American. the European market. the London stock market.
Types of Arbitration This part explores two of these relationships and associated arbitrage opportunities: y y Cross-Rate Arbitrage Geographical Arbitrage Cross-Rate Arbitrage Cross-rate arbitrage. dollar versus the British pound. for example the Japanese new date iron stock price falls from 800 Japanese Yen to 400 Japanese Yen.S. There is also a rate quoted for the U. the rise or the drop of stock market could influence the value of the stock whether to rise or drop. dollar versus the euro. .y Zero and Game In the stock market.S. allows you to exploit misalignments in cross rates. there is a rate quoted for the U. the value of this stock has been reduced to half. A cross-rate is the exchange rate between two currencies that is implied by the exchange on other currencies. Example: In New York. Together these two rates imply a rate Geographical Arbitrage Geographical arbitrage occurs when one currency sells for a different prices in two different markets. if present.
When dealing with the foreign currency exchange. For example. The attractive thing about this market is both its leverage and it liquidity. sometimes known as the Forex market. It once was reserved for the richest of the rich. Otherwise. However. While economic and political conditions are also among the things that greatly affect the Forex. it is seen as a good thing when interest rates rise and a bad thing when they fall. On the Forex. then sell the liras and buy back American dollars for a profit. one must understand the current conditions of each individual interest rate. sell it and make a profit. their currency is seen as being stronger than other currencies. While currency prices are what the market is all about. When the interest rates raise. Being aware of these things is part of making logical and rational decisions of trading. investors will want to capitalize high returns and you will see money flowing into the country. this is a market that draws people from all financial levels. you must also be aware of things that affect it. Something to remember is that money often follows interest rates. . there is nothing that affects it more than interest rates. is one that is affected by several things. The market itself is becoming one of the most popular forms of trading today. Interest rates are something that drives the foreign exchange market. sold and traded. when you have expertise in the foreign exchange market. a broker might buy a Italian lira when the lira to dollar ratio increases. The foreign exchange market.Interest Market Money from all over the world is bought. This happens because investors seek more of that currency to profit more. 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. to be able to understand the current foreign exchange market. however today with lower minimums. interest rates have a direct affect on those prices. Therefore. anyone can buy and sell currency and with possibly come out ahead in the end. it is possible to buy the currency of one country. When one country's interest rates rise.
y 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. y Alternative investments: The lender has a choice between using his money in different investments. y Inflationary expectations: Most economies generally exhibit inflation. the lender may insist on a higher rate to make up for this loss. Most economists advocate independent central banks to limit the influence of politics on interest rates. meaning a given amount of money buys fewer goods in the future than it will now. Different investments effectively compete for funds. The quick boost can influence elections. . If he chooses one. The borrower needs to compensate the lender for this. Under normal conditions. y Taxes: Because some of the gains from interest may be subject to taxes. 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. he forgoes the returns from all the others.Reasons For Interest Rate Change y Political short-term gain: Lowering interest rates can give the economy a short-run boost.
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