Exchange Rate Arbitrage

Presented By: Neha Bansal

y Arbitrage performs the function for a market system of bringing prices in one market into line with those in other markets y .Introduction 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. absolute profits may also be large from successful arbitrage. the prices are said to constitute an arbitrage equilibrium or arbitrage-free market. well-informed markets. y Rates of profit on arbitrage operations are necessarily low in competitive. it is not their intention to do so. at least. y Arbitrageurs do not take risks or. If the market prices do not allow for profitable arbitrage. but since transactions are usually very large.

the $2 difference could be an immediate profit requiring zero investment. .Example of Arbitrage If the price of a stock on the New York Stock Exchange is $10 per share. but it's $8 per share on the Frankfurt exchange.

we are quoting both exchange rates against sterling.60 in New York. . y For example.TwoTwo-point arbitrage Concerns two currencies in two geographically separated markets.55 in London and £1 = $1. y Here. let the spot exchange rate be y £1 = $1.

55 in London and £1 = $1.032. . y Selling this in New York would have returned him £1.06 y y A profit of 5 cents per £1.258.161. For this.60 in New York. £1 = $1.y Assume the arbitrageur sold $1 million in London.29. he would have received 645.

60. the sale of sterling in New York would have caused sterling to weaken there. y At the same time. pushing its value below $1. y .Rate differential coming into line The sale of dollars in London would have strengthened sterling and pushed the value of the pound above $1. y The action of arbitrageurs would bring the rates of exchange in the two centres together.55.

the arbitrageur would have been quoted the offer rate of 1. y .602.5995 Offer 1.5505 and. would have received £644.71.In terms of BID/ASK Rate y y London: GBP/USD Bid 1.24.5995 and would have received £1.953. thus. y Buying dollars in New York.5495 Offer 1.6005 Selling dollars in London. the profits would have been lower because of the bidoffer spread. That is. the arbitrageur would have been quoted the bid rate of 1.031.5505 New York: GBP/USD Bid 1.

exchange rates among different currencies may be mutually inconsistent. y . That is. Arbitrageurs will then attempt to profit from these inconsistencies and in the process will eliminate discrepancies and establish mutually consistent cross-exchange rates.ThreeThree-point (triangular) arbitrage y Exchange rates may be externally consistent but internally inconsistent. A cross-exchange rate is simply the price of a second currency expressed in terms of a third or an exchange rate calculated from two other rates.

090-120 GBP/JPY £1 = ¥ 176.720-831 y Implied Cross Rate GBP/JPY = £1 = ¥ 166.720-831 .5715-721 USD/JPY $1 = ¥ 106.y For example. Actual exchange rates GBB/USD £1 = $ 1.

Step B: Use yen to buy $. market-maker sells dollars at the offer rate of ¥106.059. which gives £1.120.5721.665.95 or a profit of 5.y y Start with £1.720.000 Step A: Use £ to buy yen. This gives $1. Step C: Use $ to buy £ Step A: Sell £ for yen.000. y . This gives ¥176.284.720. y Step B: Sell ¥ for $.000. The market-maker buys dollars at the higher rate of $1.273.58 y Step C: Sell $ for £.9%. market-maker sells the foreign currency (¥) at the bid rate of ¥176.

but be real careful about timing .There may be no such thing as a free lunch. but arbitrage remains an attractive buffet. Arbitrage can be lucrative.

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