7.2. The Spot Market rate of R 1.0076/USS and (2) selling those dollars for baht at the bid rate of B 25.2513/USS, These transactions result im the bid cross rate for the real being the bid rate forthe baht divided by the ask rate forthe real Budcrossrate _ _Bidratefor Thai baht/US.$__ 25.2513 eid rate for Tha Pa SS _ 21 = 05 0608/R Jforthereal — ~ Askvate for Brazihun real/U.SS ~ T0076 " Similarly, the baht cost of buying the real (the ask cross rate) can be found by first buying dollars for Thai baht atthe ask rate of B 25.3986/USS and then selling those dollars co buy Brazilian reas at the bid rate of R 0.9955/USS. Combining these transactions yields the ask cross rate for the real being the ask rate for the babt divided by the bid rate for the rel ‘Ask cross rate __Ask rate for Thai bahi/U.S.S 25.3986 forthe veal ~ Bid vate for Braziban real/USS — 09955 B25 5134/8 Thus, the ditect quotes for the real in Bangkok are B 25.0608—5134. Currency Arbitrage. Historically, he pervasive practice among bank dealers was to quote all currencies against the US. dollar when trading among themselves. Now, however, a growing percentage of currency trades does not involve the dollar. For example, Swiss banks may quote the euro against the Swiss franc, and German banks may quote pounds sterling in terms of, euros, Exchange traders are continually alert to the possibility of taking advantage, through currency arbitrage transactions, of exchange rate mconsistencies in different money centers. These transactions involve buying a currency in one market and selling it in another, Such activites tend to keep exchange rates uniform in the various markets Currency arbitrage transactions also explain why such profitable opportunities are fleeting, In the process of taking advantage of an arbitrage opportunity, the buying and selling of currencies tend to move rates in a manner that eliminates the profit opportunity in the future When profitable arbitrage opportunities disappear, we say that the no-arbitrage condition holds. If this condition is violated on an ongoing basis, we would wind up with a money machine, as shown in the following example. Suppose the pound sterling ts bid at $1.9422 in New York and the euro is offered at 51.4925 in Frankfurt. Atthe same time, London banks are offering pounds sterling at €1.2998 An astute trader would sell dollars for euros in Frankfurt, use the euros to acquire pounds sterling m London, and sell the pounds in New York, Specifically, if the trader begins in New York with $1 million, he could acquire €670,016.75 for $1 million in Frankfurt (1,000,000/1.4925), sell these euros for £515,476.80 in London (670,016.75/1.2998), and resell the pounds in New York for $1, 001, 159.05 (515, 476.80 x 1.9422), Thus, a few minutes’ work would yield a profit of $1,159.05. In effect, by arbitraging through the euro, the trader would be able to acquire sterling at $1.9400 in London ($1.4925 x 1.2998) and sell it at $1.9422 in New York. This sequence of transactions, known as triangular currency arbitrage, is depicted in Exhibit 7.7 In the preceding example, the arbitrage transactions would tend to cause the euro to appreciate vis-i-vis the dollar in Frankfurt and to depreciate against the pound sterling im London; at the same time, sterling would tend to fall in New York against the dollar. Acting simultaneously, these currency changes will quickly eliminate profits from this set of transactions, thereby enforcing the no-arbitrage condition, Otherwise, a money machine would exist, opening up the prospect of unlimited risk-free profits. Such profits would quickly atcract other traders, whose combined buying and selling activities would bring exchange rates back into equilibrium almost instantaneously. 269270 CHAPTER 7 + The Foreign Exchange Market Exwipit 7.7 AN EXAMPLE OF TRIANGULAR CURRENCY ARBITRAGE 4. Net profi equals $1,159.05 Now York Finish Start $1,001,158.05 $1,000,000 2, Sell $1,000,000 in Frankfurt at €1 1.4825 for ©670,018.75 Mutiptieg by Divided by stsazzie stasasie 43. Resell the pounds ‘storing n Now York at81 = $19422 for $1,001.188.05 18515,476.80 Divided by €670.016.75 London.“ €12898/¢ —————" Frankturt InLondon at £1 for 515,478.60 Opportunities for profitable currency arbitrage have been greatly reduced in recent years, given the extensive network of people—aided by high-speed, computerized information systems—who are continually collecting, comparing, and acting on currency quotes in all financial markets. The practice of quoting rates against the dollar makes currency arbitrage even simpler, The result of this activity i that rates for a specific currency tend to be the same everywhere, with only minimal deviations resulting from transaction costs APPLICATION Calculating the Direct Quote for the Euro in New York the direct quote for the dollar is €0.65 in Frankfurt, and transaction costs are 0.3%, what are the ‘minimum and maximum possible direct quotes for the euro in, New York? Solution. The object here is o find the no-arbitrage range of euro quotes—that is, the widest bid-ask spread within which any potential arbitrage profits are eaten up by Wansaction costs, It can be found a follows: Begin with an arbitrageur who converts $1 into euros in Frankfurt. The arbitrageur would receive €0,65 X 0.997, after paying transaction costs of 0.3%, Converting these euros into dollars in New York ata direct quote of, the arbitrageur would keep 0,65 x 0.997 x e x 0.997. The no-arbitrage condition requites that this quantity must be less than or equal to $1 (otherwise there would be a money machine), or e = 1/10.65(0.997)"| = $1.5477. Akematively, an arbitrageur who converted $1 into euros in New York at a rate of ¢ and took those euros to Frankfurt and exchanged them. for dollars would wind up—after paying transaction costs in both New York and Frankfurt—with (1o) x 9.997 x (1/9.65) x 0.997, Because the no-arbitrage condition requires that this quantity must not exceed $1, (0.997)? x (1/0.65e) < I,or € = $1.5292, Combining these two inequalities yields $1.5292 <¢< $1547