- 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 three forms of arbitrage activities that affect the
foreign-exchange market: Arbitrage of Goods, Arbitrage of Money and Covered-interest Arbitrage
ARBITRAGE OF GOODS (PURCHASING POWER PARITY)
- Underlying the arbitrage of goods is a very simple notion: If the price of a good differs between two markets, people will tend to buy the good in the market offering the lower price, the “cheap” market, and resell it in the market offering the higher price, the “expensive” market. Under the law of one price such arbitrage activities will continue until the price of the good is identical in both markets (excluding transactions costs, transportation costs, taxes, and so on). The arbitrage of goods across national boundaries is represented by the theory of purchasing power parity (PPP). This theory states that the prices of tradable goods, when expressed in a common currency, will tend to equalize across countries as a result of exchange rate changes. PPP occurs because the process of buying goods in the cheap market and reselling them in the expensive market affects the demand for, and thus the price of, the foreign currency, as well as the market price of the good itself in the two product markets in question.
- International economists use PPP to help them compare standards of living across countries. Consider for example Japan and Canada, converting Japan's 2006 per capita income measured in yen into U.S dollar using the average 2006 exchange rate between the yen and the dollar would yield $38,410. Canadian per capita income in 2006 when converted to U.S dollar was $36,170. This mean that the average Japanese citizen enjoys a higher income than the average Canadian citizen
- Foreign exhange analysts also use PPP theory to forecast long-term changes in exchange rates. The analysts believe that broad purchasing power imbalances between countries signal possible changes in exchange rates
- Professional traders employed by money market banks and other financial organizations seek to profit from small differences in the price of foreign exchange in different markets. Whenever the foreign-exchange market is not in equilibrium, professional traders can profit through arbitraging money. Numerous forms of foreign-exchange arbitrage are possible, but three forms are common;
- Two-point arbitrage involves profiting from price differences in two geographically distinct markets. Suppose £1 is trading for $2.00 in New York City and $1.80 in London. A foreign-exchange trader at JPMorgan Chase could take $1.80 and use it to buy £1 in London’s foreign-exchange market. The trader could then take the pound she just bought and resell it for $2.00 in New York’s foreign-exchange market. Professional currency traders can make profits through three-point arbitrage whenever the cost of buying a currency directly (such as using pounds to buy yen) differs from the cross rate of exchange.
- The cross rate is an exchange rate between two currencies calculated through the use of a third currency (such as using pounds to buy dollars and then using the dollars to buy yen). The U.S. dollar is the primary third currency used in calculating cross rates. The difference between these two rates offers arbitrage profits to foreign-exchange market professionals. The market for the three currencies will be in equilibrium only when arbitrage profits do not exist, which occurs when the direct quote and the cross rate for each possible pair of the three currencies are equal.
- Covered-interest arbitrage is arbitrage that occurs when the difference between two countries’ interest rates is not equal to the forward discount/premium on their currencies. In practice, it is the most important form of arbitrage in the foreign-exchange market. It occurs because international bankers, insurance companies, and corporate treasurers are continually scanning money markets worldwide to obtain the best returns on their short-term excess cash balances and the lowest rates on short-term loans.
COVERED-INTEREST ARBITRAGE
Covered-interest arbitrage is arbitrage that occurs when a difference between two countries' interest rates are not equal to the forward discount/premium on their currencies. In practise, it is the most important form of arbitrage in the foreign-exchange market
It occurs because international bankers, insurance companies and corporate treasurers are continually scanning money markets worldwide to obtain the best returns on their short-term excess cash balances and the lowest rates on short-term loans. In doing so, however they often want to protect, or cover (hence the term covered-interest arbitrage) themselves from exchange rate risks
The short-term capital flows that result from covered-interest arbitrage are so important to the foreign-exchange market that in practice the short-term interest rate differential between two countries determines the forward discount or forward premium on their currencies.
In summary, arbitrage activities are important for several reasons;
- Arbitrage constitutes a major portion of the $3.2 trillion in currencies traded globally each working day
- It affects the supply and demand for each of the major trading currencies
- It ties together the foreign-exchange markets, thus overcoming differences in geography (two-point arbitrage), currency type (three-point arbitrage) and time (covered-interest arbitrage)
Arbitrage truly makes the foreign-exchange market global.