Chapter_10_Exchange_Rates_and_Foreign_Ex

# This is usually the responsibility of the central

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This is usually the responsibility of the central bank.

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Objectives 4. Arbitrage and Spot Exchange Rates Understand the (near) equalization of exchange rates in different locations. How this result is ensured through the process of arbitrage under conditions of capital mobility.

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Arbitrage and Spot Exchange Rates Overview An important goal of players in the foreign exchange market is to exploit arbitrage opportunities. Arbitrage refers to a trading strategy that exploits price differences. The purest form of arbitrage involves no risk. The opportunity to make a riskless profit through trading. Market equilibrium No-arbitrage condition = no riskless profit opportunities
Arbitrage and Spot Exchange Rates 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!

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Arbitrage and Spot Exchange Rates 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. 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.
Arbitrage with Three Currencies The cross rate allows us to compare exchange rates defined in terms of different currencies. For example, consider the bilateral exchange rate E£/ \$. This can be expressed in terms of E€/\$ and E£/€: The fact that any two currencies must have equal prices in two different locations implies the same for a triangular trade involving three currencies. Arbitrage and Spot Exchange Rates

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Arbitrage and Spot Exchange Rates Arbitrage with Three Currencies
Arbitrage and Spot Exchange Rates 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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