Monday, August 17, 2009

the role of arbitrage in the foreign exchange market

The foreign exchange market consists of many different markets and institutions. Yet, at any given point in time, all markets tend to generate the same exchange rate for given currency regardless of geographical location. The uniqueneness of the foreign exchange rate regardless of geographical location occurs because of arbitrage. As you recall, arbitrage refers to the process by which an individual purchases a product (in the case foreign exchange) in a low-priced market for resale in a high-priced market for the purpose of making a profit. In the process, the price is driven up in the low-priced market for the purpose of making a profit. In the process, the price is driven up in the low-priced market and down in the high-priced market. This activity will continue until the prices in the two markets are equalized, or until they differ only by the transaction costs involved. Because currency is going bought and sold simultaneously, there is no risk in this activity and hence there are always many potential arbitragers in the market. In addition, because of the speed of communications and the efficiency of transactions in foreign exchange, the spot market quotations for a given currency are remarkably similar worldwide, and any profit spread on a given currency is quickly arbitraged away.
In world of many different currencies, there is also a possibility for arbitrage if exchange rates are not consistent between currencies. This is a situation of multicurrency arbitrage, in this case called triangular arbitrage since it involves an inconsistency between different currencies. The triangular arbitrage produces cross-rate equality, meaning that all three exchange rates are internally consistent. Arbitragers are constantly watching the foreign exchange to take advantage of such a situation. The arbitrage process is thus relied upon not only to maintain a similar individual currency value in different foreign exchange markets but also to make certain that all the cross rates between currencies are consistent.

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