Lecture 2 - FOREX Arbitrage

Question 1

Explain arbitrage.

Answer 1

Creating a position (long or short ) in order to realise a riskless (sure) profit from market disequilibrium. It means to find a price differential and exploit it. It does not involve any risk and therefore you can only gain.

Question 2

Explain speculation.

Answer 2

Creating a position in order to realise a profit from your expectations because you are expecting some prices to increase or decrease. Therefore, it involves risk taking behaviour. You do not see any price differential that you can exploit in a riskless way. You could either gain or lose. The gains could possibly higher than arbitrage but you could also make losses. Betting on the actual future price > or < expected future price. This concept of speculation is particularly important when we look at derivative contracts used in the foreign exchange market.

Question 3

Define FOREX arbitrage.

Answer 3

Buying/selling currencies in order to exploit a price differential so as to make a riskless profit.

Question 4

How to identify and exploit arbitrage opportunities in the FOREX?

Answer 4

• We start in a simple position where there are only two currencies. We initially ignore bid ask spread (so that we have an immediate and easily recognisable framework in order to identify arbitrage opportunities).
• Then we add bid ask spread and three currencies or more in order to see if we can find opportunities for arbitrage.
• We must assume perfect information, no transaction costs and lack of financial controls.

Question 5

What are the two types of arbitrage?

Answer 5

• Financial centre (two point) and cross currency (triangular).

Question 6

Why do exchange rates vary/fluctuate so much in the short run?

Answer 6

• Inventory Control. Effect on exchange rates when traders alter quotes to maintain a balance between amount of currency bought and sold.
• Asymmetric Information. Transactions in the FOREX market become information. Causes exchange rates to change due to traders’ fear that they are quoting prices to someone who knows more about the current market conditions than they do. Different traders are quoting different exchange rates. Some traders might have more/better information than others.
• Herd behaviour. If someone starts to sell, then others may start to sell too.
• Order flow (which currency is requested becomes information).

Question 7

What causes the long run fluctuations of the exchange rates?

Answer 7

• In the long run, economic factors affect the exchange rates.
• A change in demand for domestic goods relative to foreign goods will cause the movement in exchange rates.
• FOREX market’s operation motivated by international trade.
• The Trade Flow Model is a simple demand/supply model to explain the long run movement of exchange rate.
• Currency is being used for trade of goods and services.

Question 8

Arbitrage opportunities are not expected to last long as…

Answer 8

The market will readjust accordingly.