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Exchange range Quotation & Arbitrage

A foreign exchange rate is the price of one currency expected in terms of another currency.

Cross Rate: A cross rate is an exchange rate between two currencies, calculated from their common relationships with a third currency.  When cross rates differ from the direct rates between two currencies, intermarket arbitrage is possible

Exchange Rates Explanation:

Assume the quoted exchange rate is:

 $/ £: 2.0000. There are a number of points to be noted about this:

  • The first of this pair of currencies is the $ and the second is £. This distinction is important for definitions, rules etc.
  • Exchange rates are always given in terms of the number of units of the first currencyper single unit of the second currency; and so $/£: 2.0000 means that the exchange rate is $2.0000= £1.
  • The final point to note is that exchange rates are normally given to four decimal places-but not necessarily. How many decimal places are used depends upon the size of the number before the decimal point.

For example: $/£: 1.8525 and ¥/£: 225.40

Types of Foreign Exchange Quotation:

Foreign Exchange Quotation: A foreign Exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate.

01. European Quote: The foreign currency price of one dollar
         Example: BDT 75.2525/$, read as BDT 75.2525  per dollar

02. American Quote: The dollar price of a unit of foreign currency

Example: $0.0.01329/BDT, read as 0.0.01329 dollars per BDT

03. Direct Quote: A foreign exchange rate quoted as the domestic currency per unit of the foreign currency.

Direct quotation: 1 unit  of foreign currency = x Number of home currency

Example: $1 = RS 68.75 is a direct quote in INDIA

04. Indirect Quote:  A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. In an indirect quote, the foreign currency is a variable amount and the domestic currency is fixed at one unit. 

Indirect quotation: 1 unit of home currency = x Number of foreign currency units

For example:  RS 1 = $ 0.015 is an indirect quote in INDIA.

Arbitrage

Arbitrage is the process of a simultaneous sale and purchase of currencies in two or more foreign exchange markets with an objective to make profits by capitalizing on the exchange-rate differentials in various markets.

The arbitrage opportunities exist due to the inefficiencies of the market. While dealing in the arbitrage trade, an individual can make profits only out of price differences of similar or identical financial instruments traded on different exchange markets. Thus, the price differential is captured as a trade’s net payoff. This payoff should be large enough to cover the expenses incurred in executing the trade.

For example: Suppose the stock of company A is trading at Rs 2000 on BSE while the same stock is trading on NSE at Rs 2500. A trader can earn a profit of Rs 500 by buying the stock on BSE and immediately selling the same shares on NSE. This arbitrage opportunity can be availed until BSE runs out of shares of company A or until BSE and NSE adjusts the price differences so as to wipe out the arbitraging opportunity.

The importance of arbitrage lies in its ability to correspond foreign exchange rates in all the major foreign exchange markets. The arbitraging involves the transfer of foreign exchange from the market with a lower exchange rate to the market with a higher exchange rate. Hence, arbitraging equates the demand for foreign exchange with its supply, thereby acting as a stabilizing factor in the exchange markets.

The arbitrage opportunity can be availed only where the foreign exchange is free from controls, and if any, controls should be of limited significance. If the sale and purchase of foreign exchange are under severe control and regulation, then the arbitrage is not possible. Practically, the arbitrage opportunity exists for a very brief period since in the mature markets the most of the trading has been taken by the algorithm-based trading (a trading system that relies heavily on mathematical formulas and computer programs to determine the trading strategies)These algorithm-based trading are quick to spot and is quite easy for a trader to keep track.

The Arbitrage Funds are the equity-based mutual funds that try to take the advantage of price differentials (of the same asset) in the cash and derivative markets to generate returns. Simply the funds that generate money from the difference in the price of the same security in different markets are called as arbitrage funds.

The fund manager checks the difference in the price of security in the cash or derivatives markets or even on different stock exchanges such as BSE, NSE. Suppose, the price of stock in the cash market quotes Rs 120 and Rs 115 in the derivatives market. Then the fund manager would buy the stock from the derivatives market at Rs 115 and sell it in the cash market for Rs 120, thereby making a profit of Rs 5 per share for the investor.

The arbitrage funds are more suitable for the volatile markets where the fund manager can capitalize on differences in the price of securities in different markets. These funds are hybrid in nature since these offer an opportunity for the investor to concentrate the significant portion of his investments in the debt instruments. Often the fund manager uses the fixed income instruments (debt) to hedge against the equities.

Often the low risk taking investors invests in the arbitrage funds. These funds are considered more secure at the time of high and persistent volatility in the broad market. As these funds make a significant investment in equities, their tax treatment is similar to the equity funds and, therefore, enjoy the benefits of zero taxes on the long-term gains.

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