Arbitrage, Hedging, and Speculation: The Foreign Exchange Market

Arbitrage, Hedging, and Speculation: The Foreign Exchange Market

Arbitrage, Hedging, and Speculation: The Foreign Exchange Market

Arbitrage, Hedging, and Speculation: The Foreign Exchange Market

Synopsis

Explains the $1.5 trillion-a-day foreign exchange market, its trading structure, and the global environment in which it operates.

Excerpt

Chapter 1
Arbitrage, Hedging, and
Speculation: The Foreign
Exchange Market

Arbitrage, hedging, and speculation are three distinct acts in market transactions in any items of trade—goods, securities, and currencies. In this book, we will discuss these three operational strategies in the foreign exchange market, but some of these strategies can be duplicated in other markets as well. On our chapter-by-chapter exposition and exploration throughout this book, we will delineate arbitrage, hedging, and speculation from the standpoint of a market participant—a trader, an individual, or an institution— with access to market data, economic judgment, and analytical skill.

ARBITRAGE

Arbitrage is the simultaneous purchase and sale of a commodity or asset in different markets with the sole intent to make profit from the difference in buying and selling prices. Here the asset is a currency. If, for example, the dollar price of a British pound sterling is $1.60 in Frankfurt but $1.50 in Paris, a trader can buy £1 in Paris, sell that pound in Frankfurt, and make a profit of $0.10 per pound, and if the trader buys 15 million pounds (£15,000,000), he makes $1,500,000 before any transaction costs, if they exist. Therefore, arbitrage is an exploitation of misalignment of market quotes. If the market is perfectly competitive, this sort of price differential cannot exist, thus, arbitrage profit cannot exist. In this sense, arbitrage profit is a possible outcome of market imperfection in which [buy cheap and sell dear] is a feasible act of a vigilant trader.

It should be pointed out that markets are mostly efficient, and hysteresis fades away pretty soon by the forces unleashed by the acts of buying low and selling high. In the scenario described above, if it persists, then the Paris market will feel a higher demand for the pound, and the Frank-

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