Session4 - Notes - Session 4 > Chapter 7: International...

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Notes - Session 4 >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> Chapter 7: International Arbitrage and Interest Rate Parity Chapter 8: Relationships among Inflation, Interest Rates and Exchange Rates >>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>>> LOCATIONAL AND TRIANGULAR ARBITRAGE The term “arbitrage” refers to buying a commodity, including foreign exchange, in one market at one price, while simultaneously selling it in another market at a better price, in order to obtain a profit on the price differential. (If six-packs of Coca-Cola were selling at $2.50 in New York City, but at only $1.50 in New Jersey, a person doing arbitrage would make money by buying Cokes in New Jersey, and selling them in New York at a $1 profit.) Locational Arbitrage Locational arbitrage for foreign exchange is the process of buying a currency at a location where it is priced cheaply and selling it immediately at a location where it is priced high. Here's how a person could make money on currency arbitrage. Suppose there is a small discrepancy in exchange rates in different markets. In other words, suppose you can buy a dollar cheaper in London than in Tokyo. Locational arbitrage would involve no more than buying the dollar in London and selling it in Tokyo. It’s the old “buy low, sell high” process. In actual fact, locational arbitrage is much harder to do in practice than it sounds since the discrepancies in prices lasts no more than a matter of seconds. Specialists at banks or other foreign exchange firms are constantly monitoring the quotes from other banks, and quickly using locational arbitrage to earn profits whenever they notice a discrepancy. Obviously, the amateur lacks the access to the high speed quotation equipment as well as the ability to buy and sell quickly, so locational arbitrage is not likely in any of our futures. Triangular Arbitrage Triangular arbitrage capitalizes on a discrepancy in the cross exchange rate between two countries. If the quoted cross exchange rate for a currency differs from what it should be, as determined by the formula that follows, triangular arbitrage can be carried out. .For example, your textbook uses the following example. (Please note that the different exchange rates are usually at several different banks, while your textbook has tried to simplify the explanation by pretending the discrepancies are all at two banks.) Suppose a bank has quoted the British pound (pound) at $1.60/pound, the Malaysian ringgit (MYR) at $.20/ringgit and quotes a cross exchange rate of one pound + MYR8.1. Your first job is to use the cross rate formula to calculate the cross exchange rate that should exist between the pound and the franc, since the cross-rate quoted by the bank may be incorrect.
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Value of 1 pound in units of ringgit = value of pound in $/value of ringgit n $ = $1.60/pound/ $.20/ ringgit = 8 ringgit/1pound You have just calculated that the cross rate should be 8 ringgit/1 pound, but the bank is
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This note was uploaded on 02/14/2011 for the course FINANCE 640 taught by Professor Sen during the Fall '10 term at UMBC.

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Session4 - Notes - Session 4 > Chapter 7: International...

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