Arbirage in Foreign Currency Exchange Markets

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 s

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trage operations, the purpose of which is to limit the degree of risk to which the multinational business organization will be exposed. A truly skillful arbitrageur can effectively transfer all risk, with the result that the only costs incurred by the company will be the negligible transactions costs. The money markets of the world consist of sets of institutions and arrangements through which the supply and the demand for shortterm funds are brought together. The major money markets of the world have no central trading place. Rather, their activities are centered in several locations, such as New York, London, Tokyo, Singapore, and Hong Kong. Trading takes place entirely by telephone and telex, through which dealers buy and sell and reconcile transactions. These dealers in currencies engage in arbitrage, in order to take advantage of temporary (and small) price differentials. This arbitrage activity serves to keep the prices of the different currencies in the different markets relatively uniform. A study conducted in the mid1980s found a diminishing role for transaction costs in explaining the deviation of the actual forward rate of a currency from the forward parity rate.8 The study found that the existence of equilib
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Approximate Word count = 3260
Approximate Pages = 13 (250 words per page)