Page 45 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

International Financial Management

Notes few minutes work. The example has, however, not deducted the transactions expenses, telephone
charges and other costs associated with conducting the deal, from the profit. Since these costs are
minimal, we tend to ignore them here.
However, as Arbitrage continues, the exchange rate between the two currencies tends to get
equalised in the two monetary centres. What actually happens is that the sale of pounds in
London increases the supply of pounds there, thus resulting in a decrease in the dollar price of
pounds in London. In New York, Arbitrage increases the demand for pounds in New York
thereby increasing the dollar price of pounds in New York. This process continues till the dollar
prices become equal in the two countries so that Arbitrage does not remain profitable now.

In the above example, only two currencies and two monetary centres were involved in the
Arbitrage analysis. When this is so, we have Two-point Arbitrage. When three currencies and
three monetary centres are involved, we have a triangular or three-point Arbitrage. Triangular
Arbitrage also operates in the same manner as Two-point Arbitrage, though it is not very
popular. Triangular Arbitrage operates so as to ensure consistent Indirect or cross exchange
rates between the three currencies in the three monetary centres.
Consider the following exchange rates

$2 = £1 in New York
£0.2 = 1 DM in London
2.5 DM = $1 in Frankfurt
These Cross Rates are consistent because $2 = £1 = 5DM and no possibility of profitable Arbitrage
exists. But if the dollar price of pounds was $1.96 in New York, with other exchange rates
remaining the same, then it would pay to use $1.96 to purchase £1 in New York, use the £1 to buy
5DM in London and exchange the 5DM in London for $2 in Frankfurt thus realising a $0.04 profit
on each pound transferred.

Thus, Triangular Arbitrage eliminates inconsistent Cross Rates and the profitability of further
Arbitrage by increasing the demand for the Currency in the monetary centre where the Currency
is cheaper and by also increasing the supply of the Currency in the monetary centre where the
Currency is more expensive. In effect, Triangular Arbitrage results in consistent Cross Rates
among all pairs of currencies, thus helping to unify all international monetary centres into a
single market.

Self Assessment

State whether the following statement is true or false:

3. The term “Arbitrage” refers to the purchase of a Currency by Speculators in the monetary
centre where it is cheaper for immediate resale in the monetary centre where it is more
expensive so as to make a profit.

Caselet Apex Corporation (CIA)

pex Corp. is a US based MNC that has been in international business for the last
several years. It has been conducting business with all the major countries of the
Aworld. One of the countries has allowed for its Currency value to be market
determined. The Spot rate of Currency is $.85. In addition the one year forward rate being
Contd...

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