Forex arbitrage
A foreign exchange market is a market when the individuals firms and banks buy and sell foreign currencies or foreign exchange. The foreign exchange market for any currency is comprised of all the locations where exchange of dollars for other currencies takes place. Let us try to analyze the functions of foreign exchange market and why individuals, firms do and banks want to exchange one national currency for other. The answer is very clear.
The demand for foreign currency mainly arises when tourists visit other country and need to exchange their own national currency with the currency of that country, they are visiting, when a domestic firm wants to import from other nations, when an individual wants to invest abroad and so on. As a result, the nations supply of foreign currencies arises from foreign tourist expenditures, from export earnings, from receiving foreign investments etc.
Another function of foreign exchange market is the credit function. It is usually needed when goods are in transit and also to allow the buyer time to resell the goods and make the payment. In general there is 90 days permission for the importers to pay to the exporters. The exporters usually discounts the importers obligation to pay at bank, which results the exporters receives of payment on a right way and the bank will eventually collect the payment from the importer when due.
However, next come the concept, arbitrage. Arbitrage is nothing but the purchase of a currency in the monetary centre where it is cheaper, for immediate resale in the monetary centre it is more expensive, in order to make a profit. Let us consider the following example. Suppose the dollar price of pounds were $1.99 in New York and that of $2.01 in London, an arbitrageur (usually an exchange dealer of a commercial bank) would purchase pounds at $1.99 in New York and immediately resell them in London and thus realizing a profit of 0.02 per pound.
As arbitrage takes place, the exchange rate between two currencies tends to be equalized in the two monetary centers. In case, if we see that the arbitrage increases the demand for pound in New York , thereby exerting an upward pressure on the dollar price of pounds. At the same time, the sale of pounds in London will increase the supply of pounds there and thus exerting a downward pressure on the dollar price of pounds, there and this will be continue until the dollar price of pounds becomes equalize in both the countries and thus eliminating the profitability of further arbitrage.
When two currencies and two monetary centers are involved in arbitrage, we have two- point arbitrage and when the number increases to three and three monetary centers are involved, we have triangular or three-point, arbitrage. While this type is not much common, it operates in the same manner to ensure consistent indirect or crass exchange rates between the three currencies in the three monetary centers. However, it is mentionable, that there is no possibility of profitable arbitrage.
Similar to the two-point arbitrage, the triangular arbitrage increases the demand for currency in the monetary centre where the currency is expensive and quickly eliminates inconsistent cross rate as well as the profitability of further arbitrage, which results a quick equalization of exchange rates for each pair of currencies also results in consistent cross rates among all pairs of currencies, thus unifying all international monetary centers into a single market.
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