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Course Relevance
This caselet is designed for the following PGDM / MBA courses:
- International Finance : Applies the derivatives concepts to international forex markets, hedging, arbitrage and risk management.
Covers cross border investments, potential identification of scams and risk management. - Financial Derivatives : applies finance concepts to futures, forwards and swaps. How futures markets are manipulated?
Academic Concepts
- This caselet draws on multiple applications of international finance knowledge in avoiding risk and identifying possible scams in international financial markets.
- It talks about the risk of manipulation of forex derivative prices.
- It discusses the opportunities for traders in utilising the arbitrage possibilities involving three different quotes in three different trading zones.
- It talks about due diligence in dealing in foreign quotes.
This caselet is about Triangular arbitrage and to understand that we need to know what is arbitrage and how it works with Forex markets.
Arbitrage : The term arbitrage in the context of forex markets refers to an act of buying currency in one market (at lower price) and selling it in another (at higher price). Thus, the difference in exchange rates (in a specified pair of currencies) in two markets
provides an opportunity to the operators/arbitrageurs in the market to earn profit without risk. As a result, equilibrium is restored in the exchange rates of currencies in different forex markets. The essence of the arbitrage process is to buy currencies from markets where prices are lower and sell in markets where prices are higher. In operational terms, the arbitrage process is essentially a balancing operation that
does not allow the same currency to have varying rates in different forex markets on a sustainable basis.
In the context of spot markets, two types of arbitrages are plausible: (i) Geographical arbitrage and (ii) Triangular arbitrage.
Geographical Arbitrage As the name suggests, geographical arbitrage consists of buying currency from a forex market (say, London) where it is cheaper and sell in another forex market (say, Tokyo) where it is costly. Since geographical distance does not have much relevance in view of the fact that forex transactions primarily take place through telephone and fax messages, arbitrageurs will gain in buying at London and selling at Tokyo.
As an example, Just assume at two forex centres, the following Re-US $ rates are quoted:
London : Rs 47.5730 – 47.6100
Tokyo : Rs 47.6350 – 47.6675
We can find out arbitrage possibilities for an arbitrageur who has Rs 100 million.
The arbitrageur can use the following modus operandi
(i) He will buy US $ from the London forex market at the rate of Rs 47.6100, as it is cheaper there compared to the Tokyo market (Rs 47.6350). He will obtain (Rs 100 million/Rs 47.6100) US $2,100,399.075 on conversion.
(ii) He will sell US $2,100,399.075 at the rate of Rs 47.6350 per US $ and will obtain Rs 100,052,509.90.
(iii) As a result of arbitrage, he will earn a profit of Rs 52,059.90 (Rs 100,052,059.90 – Rs 100 million) without any risk.
Triangular Arbitrage As the name suggests, triangular arbitrage takes place when there are three currencies involving three markets. For this reason, triangular arbitrage is also known as a three-point arbitrage. This example illustrates the concept of such an arbitrage.
The following are three quotes in three forex markets:
$1 = Rs 48.3011 in Mumbai
£1 = Rs 77.1125 in London
£1US = $1.6231 in New York
If the arbitrageur has US $1,000,000 let us find out whether there are any arbitrage opportunities.
We can see that the arbitrage gains are possible since the cross rate between US $/British £ by using the rates at London and at Mumbai is different (Rs 77.1125/Rs 48.3011 = US $1.5965/£1) from that of New York ($1.6231). The arbitrageur can adopt the following steps to realise arbitrage gain.
(i) The arbitrageur will buy Indian rupees with US $1 million. The total proceeds he obtains is (Rs 48.3011 * $1 million US $) Rs 48,301,100.
(ii) He then converts Indian rupees in British £ at the London forex market. He receives (Rs 48,301,100/
Rs 77.1125) £626,371.8592.
(iii) He then converts £626,371.8592 at the New York forex market. He obtains (£626,371.8592 3 $1.6231)
US $1,016,664.164
(iv) Thus, he has net gain of (US $1,016,664.164 – $1,000,000) US $16,664.164
From the above illustration it can be said that the arbitrage process will set in whenever there are significant differences between cross rates and quoted rates and this process continues till there is a realignment between these rates.
Teaching Note :
This topic is relevant for the international Finance and derivatives course studied by the PGDM2 students. This covers what is an arbitrage and how to identify and utilise these opportunities in international financial markets. As we have discussed this knowledge will help in hedging and making use of opportunities.
Learning Objectives
After engaging with this caselet, students will be able to:
- Analyze how arbitrage works
- Apply risk management concepts and arbitrage in real markets
- Evaluate the risk and return of arbitrage strategies.
Key Discussion Points
- How to identify arbitrage opportunities?
- How to reduce transaction cost and to improve portfolio return?.
Discussion Questions :
- Do you think the triangular arbitrage opportunities are for real? Give your reasons.
- What is triangular arbitrage? Explain the reasons for the mismatch in prices.
References :
- Fenn, D. J., Howison, S. D., McDonald, M., Williams, S., & Johnson, N. F. (2009). The mirage of triangular arbitrage in the spot foreign exchange market. International Journal of Theoretical and Applied Finance, 12(08), 1105-1123..
- Aiba, Y., & Hatano, N. (2004). Triangular arbitrage in the foreign exchange market. Physica A: Statistical Mechanics and its Applications, 344(1-2), 174-177..
3. Moosa, I. (2001). Triangular arbitrage in the spot and forward foreign exchange markets. Quantitative Finance, 1(4), 387..
4. Madhumathi. R & Ranganatham. M (2012).
“Derivatives and Risk Management.”
