Arbitrage

Definition

Arbitrage is the practice of taking advantage of a price difference between two or more markets by simultaneously buying and selling an asset to profit from the imbalance. It is a key concept in understanding the dynamics of foreign exchange markets and how supply and demand shifts can impact currency prices.

5 Must Know Facts For Your Next Test

1. Arbitrage opportunities in foreign exchange markets arise when the same asset (a currency) can be bought and sold at different prices across markets.
2. Arbitrageurs exploit these price discrepancies by simultaneously buying the asset in the lower-priced market and selling it in the higher-priced market, pocketing the difference as profit.
3. The presence of arbitrage forces prices to converge, as arbitrageurs' actions push the prices in the two markets towards equilibrium.
4. Arbitrage helps to ensure that the law of one price is maintained, where identical assets must have the same price across all markets.
5. Efficient market hypothesis suggests that arbitrage opportunities should be quickly exploited, making it difficult to consistently profit from price discrepancies.

Review Questions

• Explain how arbitrage helps to ensure the law of one price in foreign exchange markets.
  • Arbitrage plays a crucial role in maintaining the law of one price in foreign exchange markets. When the same currency can be bought and sold at different prices across markets, arbitrageurs will exploit this price discrepancy by simultaneously buying the currency in the lower-priced market and selling it in the higher-priced market. This action pushes the prices in the two markets towards equilibrium, ensuring that identical currencies have the same price across all markets. The presence of arbitrage opportunities incentivizes traders to quickly eliminate any price differences, effectively enforcing the law of one price.
• Describe how the efficient market hypothesis relates to the prevalence of arbitrage opportunities in foreign exchange markets.
  • The efficient market hypothesis suggests that asset prices, including currency exchange rates, fully reflect all available information. In an efficient market, arbitrage opportunities should be quickly identified and exploited by traders, causing prices to converge and eliminating any persistent price discrepancies. The efficient market hypothesis implies that it should be difficult to consistently profit from arbitrage in foreign exchange markets, as any price differences would be rapidly eliminated through the actions of arbitrageurs. The presence of arbitrage opportunities in a market may, therefore, be seen as a violation of the efficient market hypothesis, as it suggests that prices do not fully reflect all available information.
• Analyze how shifts in the demand and supply of currencies in foreign exchange markets can create arbitrage opportunities that are exploited by traders.
  • Shifts in the demand and supply of currencies in foreign exchange markets can lead to temporary price discrepancies that create arbitrage opportunities. For example, if the demand for a currency increases in one market, causing its price to rise, while the supply of that currency remains unchanged in another market, a price difference will emerge between the two markets. Arbitrageurs can then profit by buying the currency in the lower-priced market and selling it in the higher-priced market. This arbitrage activity will push the prices in the two markets back towards equilibrium, effectively eliminating the price discrepancy. The exploitation of these arbitrage opportunities by traders helps to ensure that the law of one price is maintained and that foreign exchange markets remain efficient.

Related terms

Foreign Exchange Market: The global marketplace where currencies are traded, allowing for the exchange of one currency for another.

Spot Rate: The current market price at which a currency can be bought or sold for immediate delivery.

Efficient Market Hypothesis: The theory that asset prices fully reflect all available information, making it impossible to consistently outperform the market through active trading.