Equilibrium on Spot Markets

Equilibrium on Spot Markets

In inter-bank operations, the dealers indicate a buying rate and a selling rate without knowing whether the counterparty wants to buy or sell currencies. That is why it is important to give 'good' quotations. When differences exist between the Spot rates of two banks, the arbitrageurs may proceed to make arbitrage gains without any risk. Arbitrage enables the re-estab­lishment of equilibrium on the exchange markets. However, as new demands and new offers come on the market, this equilib­rium is disturbed constantly.

On the Spot exchange market, two types of arbitrages are possible:

(1) Geographical arbitrage, and

(2) Triangular arbitrage.

ó GEOGRAPHICAL ARBITRAGE

Geographical arbitrage consists of buying a currency where it is the cheapest, and selling it where it is the dearest so as to make a profit from the difference in the rates. In order to make an arbitrage gain, the selling rate of one bank needs to be lower than the buying rate of the other bank. Example explains how geographical arbitrage gain is made.

Example: Two banks are quoting the following US dollar rates:

Bank A: Rs 42.7530-7610

            Bank B: Rs 42.7650-7730

Find out the arbitrage possibilities.

Solution: An arbitrageur who has Rs 10, 00,000 (let us suppose) will buy dollars from the Bank A at a rate of Rs 42.76107$ and sell the same dollars at the Bank B at a rate of Rs 42.7650/$.

Thus, in the process, he will make a gain of

                                                   Rs 10, 00,000 x (42.7650)-Rs 10, 00,000

                                                       42.7610

Or

                                                     Rs 93.50

Though the gain made on Rs 10, 00,000 is apparently small, if the sum involved was in couple of million of rupees, the gain would be substantial and without risk.

It is to be noted that there will be no geographical arbitrage gain possible if there is an overlap between the rates quoted at two different dealers. For example, consider the following two quotations:

Dealer A: Rs 42.7530-7610

Dealer B: Rs 42.7600-7700

                                               

                                                    42.7530                               42.7610

                                         

                      42.7600                                  42.7700

Since there is an overlap between the rates of dealers A and B respectively, no arbitrage gain is possible, unlike in the exam­ple

ó TRIANGULAR ARBITRAGE

Triangular arbitrage occurs when three currencies are involved. This can be realised when there is distortion between cross rates of currencies. Example illustrates the triangular arbitrage.

Example: Following rates are quoted by three different dealers:

£/US $:                        0.6700……….Dealer A

FFr/£:                          8.9200 ………Dealer B

FFr/US $:                   6.1080 ………Dealer C

Are there any arbitrage gains possible?

Solution: Cross rate between French franc and US dollar is 0.6700 x 8.9200 or FFr 5.9764/US $. Compare this with the given rate of FFr 6.1080/US $. Since there is a difference between the two FFr/$ rates, there is a possibility of arbitrage gain. The following steps have to be taken:

1. Start with US $ 1,00,000 and acquire with these dol­lars a sum of FFr 6,10,800 (1,00,000 x 6.1080)
2. Convert these French francs into Pound sterling, to get £ 68475.34 (6,10,800/8.92
3. Further convert these Pound sterling into US dollar, to obtain $ 1,02,202 (68,475.34/0.67).

Thus, there is a net gain of US $ 2,202. Of course, the real gain will be less, as we have not taken into account the transac­tion costs here.

The arbitrage operations on the market continue to take place as long as there are significant differences between quoted and cross rates. These arbitrages lead to the re-establishment of the equilibrium on currency markets.