ARBITRAGE IN THE CURRENCY MARKET

Arbitrage in the Currency Market

Arbitrage in the Currency Market

Introduction

In this paper we will be discussing and developing linear programming model for Arbitrage. We will be considering the world's currency market. A forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of this disparity (Garman, 1976: 257). 

For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR currency pair. Bank A sets the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader would take one euro, convert that into dollars with Bank A and then back into Euros with Bank B. The end result is that the trader who started with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if trading fees are not taken into account.

Arbitrage in the Currency Market 

Arbitrage is one of the fundamental pillars of financial economics. It seems to be generally accepted that financial markets do not offer risk-free arbitrage opportunities, at least when allowance is made for transaction costs. This notion is directly related to the law of one price, which postulates that in well-functioning, efficient financial markets identical securities must have the same price, no matter how they are created (Garman, 1976: 257). For example, if a derivative instrument can be created using two different sets of underlying securities, then the total price for each derivative instrument would be the same or else an arbitrage opportunity would exist. Arbitrage is the mechanism that should ensure the validity of the law of one price.

While the assumption of no arbitrage is likely to be reasonably mild or valid in several contexts in finance, violations of the law of one price can be rationalized on several grounds. In general terms, the absence of arbitrage opportunities gives rise to the so-called 'arbitrage paradox', first pointed out by Grossman and Stiglitz (1976, 1980). That is, if arbitrage is never observed, market participants may not have sufficient incentives to watch the market, in which case arbitrage opportunities could arise. A possible resolution to this paradox is for very short-term arbitrage opportunities to arise, inviting traders to exploit them, and hence be quickly eliminated. Also, microstructure theory shows how price differences may occur for identical assets in markets that are less than fully centralized or with an imperfect degree of transparency.

£

$

€

¥

1 £

1.563

1.198

121.652

1 $

0.640

0.767

77.821

1 €

0.835

1.305

101.528

1 ¥

0.008

0.013

0.010

Conditions for Arbitrage

Currency arbitrage involves the exploitation of the differences in quotes rather than movements in the exchange rates of the currencies in the currency pair. Forex traders typically practice two-currency arbitrage, in which the differences between the spreads of two currencies are exploited. Traders can also practice three-currency arbitrage, also known as triangular arbitrage, which is a more ...