THE FOREIGN EXCHANGE MARKET
Chapter 7 is basically institutional in nature although it opens by discussing the rationale for a foreign exchange
market, namely to facilitate the transfer of purchasing power denominated in one currency to purchasing power
denominated in another currency. Like other financial markets, the foreign exchange market facilitates trading in
financial assets by lowering transaction costs.
The balance of the chapter provides the institutional framework of the foreign exchange market, both spot and
forward transactions. It discusses pricing conventions, costs, size, and participants, and goes through some of the
mechanics of foreign exchange trading. I always illustrate this subject matter with quotes found in
The Wall Street
. Every issue of the
(Section C) contains a story on the foreign exchange market, providing spot
quotations for the Canadian dollar, pound sterling, Swiss francs, euros, and Japanese yen. The financial section also
carries a more extensive listing of spot and forward prices for about forty currencies.
SUGGESTED ANSWERS TO “ARBITRAGING CURRENCY CROSS RATES”
Do any triangular arbitrage opportunities exist among these currencies? Assume that any deviations from the
theoretical cross rates of 5 points or less are due to transaction costs.
Unfortunately, there are no shortcuts here. It is necessary to try out each possibility. Here are the 4
arbitrage opportunities that I found. If anyone finds any additional ones, please contact me at my email address:
Convert dollars to SFr, SFr to DKr, and DKr back to dollars. The profit per dollar equals $1 x 1.5780 x
3.3818/5.3033 - $1 = $0.0063.
Convert dollars to DKr, DKr to pounds, and pounds back to dollars. The profit per dollar equals $1 x
5.3021 x .12381/.6510 - 1 = $0.0084.
Convert dollars to pounds, pounds to DKr, and DKr back to dollars. The profit per dollar equals $1 x .
6502 x 8.2031/5.3033 - 1 = $0.0057.
Convert dollars to yen, yen to DKr, and DKr back to dollars. The profit per dollar equals $1 x 123.569 x .
04315/5.3033 - 1 = $0.0054.
How much profit could be made from a $5 million transaction associated with each arbitrage opportunity?
All the answers are based on rounding the arbitrage profit per dollar to the fourth decimal place.
The profit for the $/SFr/DKr/$ arbitrage will be $5,000,000 x 0.0063 = $31,500.
The profit from the $/DKr/£/$ arbitrage will be $5,000,000 x 0.0084 = $42,000.
The profit from the $/£/DKr/$ arbitrage will be $5,000,000 x 0.0057 = $28,500.
The profit from the $/¥/DKr/$ arbitrage will be $5,000,000 x 0.0054 = $27,000.