ch10 (7) - • Differences mean that there are riskless...

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Arbitrage with Two Currencies Example Take advantage of differences in price of dollars quoted in New York and London: E £/$ NY = £0.50 per dollar E £/$ London = £0.55 per dollar A NY trader can make a riskless profit by selling $1 in London for 55p, using the proceeds to buy 55/50=$1.10 dollars in NY. An instant 10% riskless profit! Arbitrage with Two Currencies Example: Market adjustment of the £/$ exchange rate As investors take advantage of this arbitrage opportunity, the demand for dollars in NY rises, causing an increase in the exchange rate (£ price of $ rises). Similarly, the supply of dollars in London rises, causing a decrease in the exchange rate (£ price of $ falls). This process continues until the exchange rates in London and New York converge to the same level.
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Unformatted text preview: • Differences mean that there are riskless profits lying around • In today’s markets, equalization occurs very, very quickly indeed! • Miniscule spreads may remain (less than 0.1%), due to transaction costs. • Cross Rates and Vehicle Currencies • The vast majority of currency pairs are exchanged through a third currency. • This is because some foreign exchange transactions are relatively rare, making it more difficult to exchange currency directly. • When a third currency is used in these types of transactions, it is known as a vehicle currency. • As of April 2007, the most common vehicle currency was the U.S. dollar – used in 86% of all foreign exchange transactions. • The euro, Japanese yen, and British pound are also used as vehicle currencies....
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