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Arbirage in Foreign Currency Exchange Markets

A DISCUSSION OF SOLUTIONS AND EMPIRICAL RESULTS OF THE APPLICATION OF ARBITRAGE IN FOREIGN

Solutions and results of studies of arbitrage applications in foreign currency exchange markets are considered in this chapter. The term arbitrage refers to purchases in one market and sales in another market that, together, have the effect of maintaining the prices of comparable items traded in the affected markets within the limits defined by the cost of buying the items in one market and selling them in another. Thus, it can be seen, at once, that the use of arbitrage is a method of limiting riskof establishing the boundaries, so to speak, of risk.

Arbitrage transactions, by definition, are either simultaneous, or nearly so; thus, the conduct of arbitrage activities tends to maintain prices in different markets for similar items within a reasonable alignmentwithin the arbitrage limits. Although the principal effect of arbitrage transactions is to bring about a relation among prices of similar items according to the cost of converting the items from one market to another, there need not be certainty about the outcome.

The core of arbitrage pricing theory (APT) is that the return generating process for a population of N assets is a linear relationship with systematic factors associated with a given portfolio.1 The conclusion of the theory is that the mean premium return vector lies in a k dimensional sub space of the factor loadings.2 A test of the arbitrage pricing theory in the early1980s concluded that "if the performance of the k portfolios is not significantly less than the performance potential of the complete set of N assets, then the k factor hypothesis is accepted."3

Another test of the APT was conducted in the late1980s. This study found that "factor scores developed using different samples explain the returns for other samples and various groupings of these samples."4 The study also found that, as a key issue...

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Arbirage in Foreign Currency Exchange Markets. (1969, December 31). In LotsofEssays.com. Retrieved 22:00, March 28, 2024, from https://www.lotsofessays.com/viewpaper/1683681.html