INTERNATIONAL FINANCIAL MANAGEMENT

TOPIC- ARBITRAGE

Submitted byASHISH KURAR 253, MADHUR MALIK 204. PARDEEP SINGH 221

ARBITRAGE

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost. In principle and in academic use, an arbitrage is risk-free; in common use, it may refer to expected profit, though losses may occur, and in practice, there are always risks in arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to differences between similar assets.

CONDITIONS FOR ARBITRAGE

Arbitrage is possible when one of three conditions is met: 1. The same asset does not trade at the same price on all markets ("the law of one price"). 2. Two assets with identical cash flows do not trade at the same price. 3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities). Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically, and even then, when each leg of the trade is executed the prices in the market may have moved. Missing one of the legs of the trade (and subsequently having to trade it soon after at a worse price) is called 'execution risk' or more specifically 'leg risk'. In the simplest example, any good sold in one market should sell for the same price in another. Traders may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price

arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.

TYPES OF ARBITRAGE
There are three types of arbitrage. These can be named as follows1. LOCATIONAL ARBITRAGE 2. TRIANGULAR ARBITRAGE 3. COVERED INTEREST ARBITRAGE

LOCATIONAL ARBITRAGE
Commercial banks providing foreign exchange services normally quote about same rates on currencies, so shopping around may not necessarily lead to a more favorable rate. If the demand and supply conditions for a particular currency vary among banks, the banks may price that currency at different rates, and market forces will force realignment. When quoted exchange rates vary among locations, participants can capitalize on the discrepancy. Specifically, they can use locational arbitrage, which is the process of buying a currency at the location where it is priced cheap and immediately selling it at another location where it is priced higher. For e.g. - Banks A and B serve the foreign exchange market by buying and selling currencies. The exchange rate quoted at bank A for pound is$1.60, while the exchange rate quoted at bank B is $1.61. Now the above example gives a foreign exchange player to do arbitrage by buying British pound from bank A and selling it to bank B and can gain $.01 per pound. The gain is risk free in that the investor knew when he purchased the pounds and how much he could sell them for.

CONSEQUENCES OF LOCATIONAL ARBITRAGE

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and

reselling are small relative to the difference in prices in the different markets. Arbitrage moves different currencies toward purchasing power parity. As an example, assume that a car purchased in the United States is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, and sell them in Canada. Canadians would have to buy American Dollars to buy the cars, and Americans would have to sell the Canadian dollars they received in exchange for the exported cars. Both actions would increase demand for US Dollars, and supply of Canadian Dollars, and as a result, there would be an appreciation of the US Dollar. Eventually, if unchecked, this would make US cars more expensive for all buyers, and Canadian cars cheaper, until there is no longer an incentive to buy cars in the US and sell them in Canada. More generally, international arbitrage opportunities in commodities, goods, securities and currencies, on a grand scale, tend to change exchange rates until the purchasing power is equal. In reality, of course, one must consider taxes and the costs of travelling back and forth between the US and Canada. Also, the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada, due, among other things, to the different emissions and other auto regulations in the two countries. In addition, our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada. Similarly, most assets exhibit (small) differences between countries, transaction costs, taxes, and other costs provide an impediment to this kind of arbitrage. Similarly, arbitrage affects the difference in interest rates paid on government bonds, issued by the various countries, given the expected depreciations in the currencies, relative to each other.

TRIANGULAR ARBITRAGE
Triangular arbitrage (sometimes called triangle arbitrage) refers to taking advantage of a state of imbalance between three foreign exchange markets: a combination of matching deals is struck that exploit the imbalance, the profit being the difference between the market prices. Triangular arbitrage offers a risk-free profit (in theory), so opportunities for triangular arbitrage usually disappear quickly, as many people are looking for them, or they simply never occur as everybody knows the pricing relation. Consider the three foreign exchange rates among the Canadian dollar, the U.S. dollar, and the Australian dollar. Triangular arbitrage will produce a profit whenever the following relation does not hold: CD$/US$ * AU$/CD$ = AU$/US$. For example if you can trade at these exchange rates


the Canadian dollar (CD$) against the US dollar (US$) is CD$1.13/US$1.00 (1 US$ gets you CD$1.13) the Australian dollar (AU$) against the US dollar (US$) is AU$1.33/US$1.00 (1 US$ gets you AU$1.33) the Australian dollar (AU$) against the Canadian Dollar (CD$) is AU$1.18/CD$1.00 (1 CD$ gets you AU$1.18)

1.13 * 1.18 = 1.3334 > 1.3300, thus mispricing has occurred.

To take advantage of the mispricing, starting with US$10,000 to trade:



1st buy Canadian dollars with US dollars: US$10,000 * (CD$1.13/US$1) = CD$11,300 2nd buy Australian dollars with Canadian dollars: CD$11,300 * (AU$1.18/CD$1.00) = AU$13,334 3rd buy US dollars with Australian dollars: AU$13,334 / (AU$1.33/US$1.0000) = US$10,025 Net risk free profit: US$25.00

A profit maximizing trader presented with these prices will trade up to the maximum size possible, or equivalently do the trade as many times as possible, until one of the traders on the other side of one of the deals changes his price. In practice currencies are quoted with a bid-ask spread, so a trader should be careful that he is actually buying at the quoted ask price, and selling at the quoted bid price. Other transaction costs, such as commissions often prevent the trade from being profitable. Traders who attempt to make a profit this way typically use sophisticated software programs to automate the process. Traders may also use this triangular relation to take a synthetic position if, for some reason, they cannot otherwise trade a specific currency pair. For example, if a trader wanted to buy Australian dollars with US dollars, he could instead first buy Canadian dollars with US dollars, and then buy the Australian dollars with the Canadian dollars. Using the prices in the above example, he would


1st buy Canadian dollars with US dollars: US$10,000 * (CD$1.13/US$1) = CD$11,300 2nd buy Australian dollars with Canadian dollars: CD$11,300 * (AU$1.18/CD$1.00) = AU$13,334

For an effective price of AU$1.3334/US$1.00. In practice, if two of the markets exist, the third will also be available to trade and any apparent benefit of using the synthetic purchase or sale will be overcome by increased transaction costs.

IS TRIANGULAR ARBITRAGE POSSIBLE?

Although triangular arbitrage opportunities exist, this does not necessarily mean that a trading strategy that seeks to take advantage of these misspricings is profitable. The three constituent trades of a triangular arbitrage transaction can be submitted extremely fast using an electronic trading system, but there is still a delay from the time that the opportunity is identified, and the trades initiated, to the time that the trades arrive at the price source. Although this delay is typically only of the order of milliseconds, it is nonetheless significant. If the trader places each trade as a limit order that will only be filled at the arbitrage price, if one of the prices moves, due to trading activity or the removal of a price by the party posting it, the transaction will not be completed. If a trader does not complete an arbitrage transaction it will cost them the amount by which the price has moved from the arbitrage price to exit their position. In the foreign exchange market there are many market participants competing for each arbitrage opportunity; for arbitrage to be profitable a trader would need to identify and execute each arbitrage opportunity faster than their competitors. These competitors are also likely to be continually striving to increase their execution speeds - leading to an electronic trading arms race. Given the resources needed to stay ahead in this race, it is extremely costly to maintain the fastest execution speeds, and thus to regularly beat other competitors to the arbitrage prices over a prolonged period of time. This, along with other transaction costs such as brokerage, the network connectivity required to access the market, and the cost of developing and supporting a sophisticated electronic trading system, is likely to severely restrict the profitability of triangular arbitrage. In practice,

to profit from triangular arbitrage over prolonged periods, a trader would need to trade more quickly than other market participants to a degree that appears unfeasible.

COVERED INTEREST ARBITRAGE

Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains. Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults the investor may lose on both the bond and the forward contract. EXAMPLE: In this example the investor is based in the United States and assumes the following prices and rates: spot USD/EUR = $1.2000, forward USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.
  

Exchange USD 1,200,000 into EUR 1,000,000 Buy EUR 1,000,000 worth of euro-denominated bonds Sell EUR 1,025,000 via a 1 year forward contract, to receive USD 1,260,750, i.e. agree to exchange the Euros back into US dollars in 1 year at today's forward price. At the expiry of one year, two transactions occur consecutively. First, the euro-denominated bond delivers EUR 1,025,000. Secondly, the forward

contract turns the EUR 1,025,000 into USD 1,260,750. So, the earning is USD 60,750. Had the investment been made in dollar, the return would have been only 4%. But, in this case, the two transactions can be viewed as resulting in an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1% The above discussion does not consider the cost of capital. Alternatively, if the USD 1,200,000 were borrowed at 4%, USD 1,248,000 would be owed in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD 12,750 in 1 year.