Flashcards in Finc 327 Ch 7 arbitrage Deck (14)
capitalizing on a discrepancy in quoted prices by
making a riskless profit.
process of buying a currency at a location where it is priced
cheap and then immediately selling it at some other location where it is priced higher
Banks's ask price
price that the bank is selling currency for and what you are buying for
bank's bid price
price that the bank is buying currency for and what you are selling for
Gains from Locational Arbitrage
Your gain from locational arbitrage is based
on two factors: the amount of money that you use to capitalize on the exchange rate
discrepancy; and the size of that discrepancy.
Realignment Due to Locational Arbitrage
the high demand for New Zealand dollars at North Bank (resulting from arbitrage activity) will cause a shortage of New Zealand dollars there. As a result of this shortage,
North Bank will raise its ask price for New Zealand dollars. The excess supply of New Zealand
dollars at South Bank (resulting from sales of New Zealand dollars to South Bank in exchange for
U.S. dollars) will force South Bank to lower its bid price. As the currency prices are adjusted, gains
from locational arbitrage will be reduced.
If a quoted cross exchange rate differs from
the appropriate cross exchange rate (as determined by the preceding formula), you can
attempt to capitalize on the discrepancy.
triangular arbitrage math
USD to pounds (ask rate) selling USD
pounds to ringgit (bid rate) buying ringgit
ringgit to USD (bid rate) buying USD
Realignment Due to Triangular Arbitrage
1. Participants use dollars to purchase
Bank increases its ask price of pounds with respect to the
2. Participants use pounds to purchase
Bank reduces its bid price of the British pound with respect
to the ringgit; that is, it reduces the number of ringgit to be
exchanged per pound received.
3. Participants use Malaysian ringgit to
purchase U.S. dollars.
Bank reduces its bid price of ringgit with respect to the
Covered interest arbitrage
the process of capitalizing on the difference in interest rates between two countries while covering your exchange rate risk with a forward contract.
Realignment Due to Covered interest arbitrage
As many investors capitalize on covered interest arbitrage, there is downward pressure on the 90-day forward rate. Once the forward rate has a discount
from the spot rate that is about equal to the interest rate advantage, covered interest arbitrage
will no longer be feasible.
Covered interest arbitrage using bid ask spread
1. convert using ask quote
2. amt grows in bank using interest rate
3. sell amt at forward rate aka bid quote
interest rate parity (IRP).
When market forces cause interest rates and exchange rates to adjust such that covered
interest arbitrage is no longer feasible