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Arbitrage Arbitrage is the riskless purchase of a product in one market for immediate resale in a second market in order to profit from a price discrepancy. There are two types of arbitrage activities that affect the foreign-exchange market: arbitrage of goods; and arbitrage of money.


Arbitrage 8- 2 Arbitrage of Goods Arbitrage of Money

Arbitrage Trading   :

Arbitrage Trading   “Arbitrage” trading is simply the trading of securities when the opportunity exists during the trading day to take advantage of differences in value between the markets the trades are made within. Arbitrage trading takes place all day long on most days that the markets are active. 8- 3

PowerPoint Presentation:

Arbitrage traders will buy and sell the same or closely related securities at the same time. They take advantage of the price or value differences in two separate markets such as the NSE and the BSE futures. In perfect securities markets there would never be any arbitrage traders or trades. Since the securities markets are not perfect when news or other information moves a security or index they can and often do become unequal in price temporally. If the markets were perfect all identical securities would trade at the same value or price on each market they were traded on. 8- 4


Example The example of arbitrage trading. Lets say there is a Company that releases good news in a press release. The stock starts to trade higher on the NSE, and there are call options available for the stock on the BSE which have not had any or little action or volume. If you jump on the options before they catch up with the climbing stocks price you can often make money by selling the stock and buying the options at the same time. Remember the price disparities that offer the opportunities will not last long, seconds is the norm. 8- 5

Theory of Purchasing Power Parity:

Theory of Purchasing Power Parity 8- 6 If prices of tradable goods are different across countries, people will profit from arbitraging Arbitrage will continue until law of one price is met: price of a good is identical in both markets (excluding transaction costs, transportation costs, taxes, etc.)

Theory of Purchasing Power Parity:

Theory of Purchasing Power Parity 8- 7 Prices of tradable goods, when expressed in a common currency, will tend to equalize across countries Suppose bundle of goods sell for C$125 and US$100 when the exchange rate is: C$=US$.80 PPP exists because goods sell for the same price in either country

PowerPoint Presentation:

8- 8 NOW SUPPOSE WE HAVE CANADIAN INFLATION OF 20% BUNDLE OF TRADABLE GOODS 100 US $ (no change in US prices) 150 C $ (inflation raises Canadian prices) But now goods are cheaper in US if C$ = $.80 US Canadians take 150C$, get 120 US$, go to U.S., buy goods for 100 US$

PowerPoint Presentation:

8- 9 NEW EQUILIBRIUM OCCURS WHEN EXCHANGE RATE CHANGES TO C$ = .67 US$ Goods now the same price in US and Canada Canadians take 150C$, get 100 US$, can buy goods for the same price in both countries

Arbitrage of Money:

Arbitrage of Money 8- 10 Two-point Covered-interest Three-point


TWO POINT (OR GEOGRAPHIC) ARBITRAGE 8- 11 Suppose $1 =100 Yen in Tokyo Suppose $1 = 98 Yen in New York City Is there a way of making a riskless profit by simultaneously buying in one market and selling in another market?


WHAT SHOULD YOU DO? 8- 12 Yen is more expensive in New York than in Tokyo (or dollar is more valuable in Tokyo than in New York) Take a $1, buy yen in Tokyo (get 100 Yen) Take 100 Yen, sell them in New York for $1.02 You’ve made a riskless profit of $.02


WHAT’S THE MARKET IMPLICATION? 8- 13 When will it stop?--when you can’t make any arbitrage profits--that is, the exchange rate will be the same in NYC and Tokyo NY Tokyo Value of Y Value of Y Arbitrage


TRIANGULAR OR THREE POINT ARBITRAGE 8- 14 Consider three currencies: exchange rates between each pair of currencies are the same everywhere (no geographic arbitrage possibilities) But arbitrage profits may exist if exchange rate between any two currencies differs from the cross-rate of exchange between them

Three point arbitrage - Example:

Three point arbitrage - Example 8- 15 3 markets: London, NY, Tokyo Suppose: $2 = one pound Suppose: $1= 120 yen Suppose: one pound = 200 yen Can I make a profit by exchanging one currency for another and then for another?

Figure 8.6 Three-Point Arbitrage:

Figure 8.6 Three-Point Arbitrage 8- 16

Cross-rate of exchange:

Cross-rate of exchange 8- 17 Exchange rate between two currencies A and B calculated by converting currency A into currency C, then using currency C to purchase currency B U.S. dollar is normally “currency C” because of the liquidity of the US dollar in the FX market

Opportunity for 3-point Arbitrage:

Opportunity for 3-point Arbitrage 8- 18 Compare the cost of buying a foreign currency directly to buying it through some third currency Can make arbitrage profits if the two are not equal Arbitrage profits disappear when: Pa/Pb = (Pa/Pc) x (Pc/Pb) (buy directly) (buy through a 3rd currency)


COVERED INTEREST ARBITRAGE 8- 19 Money managers around the world seek the highest rate of return, measured in their own currency Particularly in the short term market, money managers would like to obtain higher ROR, but don’t want to incur exchange rate risk


COVERED INTEREST ARBITRAGE 8- 20 Seek higher interest rates in foreign markets, but cover your exchange rate exposure Accomplish this by investing in an overseas market, but COVERING your exposure by engaging in a spot vs. forward swap When investing short-term overseas, buy the foreign currency spot, sell it forward


COVERED INTEREST ARBITRAGE 8- 21 Money market managers compare ROR in domestic market with covered ROR in overseas markets Have to compare higher interest rates they earn overseas with “locked-in” loss on currency conversion

Equilibrium condition: CIA:

Equilibrium condition: CIA 8- 22 Equilibrium condition (no CIA possible): interest rate differential = forward discount or premium on the foreign currency If equality doesn’t hold, then CIA profits are possible

International Capital Market:

International Capital Market Major International Banks International Bond Market Global Equity Markets Offshore Financial Centers

Table 8.1 The World’s Largest Banks:

Table 8.1 The World’s Largest Banks 8- 24 ING Group Fortis Citigroup Dexia Group HSBC Holding BNP Paribas Credit Agricole Deutsche Bank Bank of America Corp. HBOS

Establishment of Overseas Banking Operations:

Establishment of Overseas Banking Operations 8- 25 Subsidiary bank Affiliated bank Branch bank

The Eurocurrency Market:

The Eurocurrency Market 8- 26 Originated in the early 1950s Eurodollars – U.S. dollars deposited in European bank accounts Euroyen Europounds Eurocurrency – currency on deposit outside in banks worldwide Euroloans quoted on basis of LIBOR

The International Bond Market:

The International Bond Market 8- 27 Major source of debt financing for: World’s governments International organizations Larger firms Two types of bonds Foreign bonds Eurobonds

Figure 8.7 International Bond Issues 2007, by Currency (in billions of U.S. dollars):

Figure 8.7 International Bond Issues 2007, by Currency (in billions of U.S. dollars) 8- 28

Global Equity Markets:

Global Equity Markets Start-up companies are no longer restricted to raising new equity only from domestic sources Development of country funds Mutual fund specializing in a given country’s funds

Offshore Financial Centers:

Offshore Financial Centers 8- 30 Focus on offering banking and other financial services to nonresident customers Locations Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands Antilles, Singapore, Luxembourg, Switzerland

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