International macroe.. - Free

1.1. INTERNATIONAL FINANCIAL MARKETS 3The equilibrium condition in cross-rate markets is given by the absenceof unexploited triangular arbitrage proÞts. To illustrate, assumethat there are no transactions costs and consider 3 currencies–the dollar,the euro, and the pound. Let S 1 be the dollar price of the pound, S 2be the dollar price of the euro, and S3 x be the euro price of the pound.Thecross-ratemarketisinequilibriumiftheexchangeratequotationsobeyS 1 = S3 x S 2. (1.1)The opportunity to earn riskless arbitrage proÞts are available if (1.1)is violated. For example, suppose that you get price quotations of S 1 =1.60 dollars per pound, S 2 =1.10 dollars per euro, and S3 x =1.55eurosper pound. An arbitrage strategy is to put up 1.60 dollars to buyone pound, sell that pound for 1.55 euros and then sell the euros for1.1 dollars each. You begin with 1.6 dollars and end up with 1.705dollars, which is quite a deal. But when you take money out of theforeign exchange market it comes at the expense of someone else. Veryshort-lived violations of the triangular arbitrage condition (1.1) mayoccasionally occur during episodes of high market volatility, but we donot think that foreign exchange dealers will allow this to happen on aregular basis.Transaction TypesForeign exchange transactions are divided into three categories. TheÞrst are spot transactions for immediate (actually in two working days)delivery. Spot exchange rates are the prices at which foreign currenciestrade in this spot market.Second, swap transactions are agreements in which a currency sold(bought) today is to be repurchased (sold) at a future date. The priceof both the current and future transaction is set today. For example,you might agree to buy 1 million euros at 0.98 million dollars today andsell the 1 million euros back in six months time for 0.95 million dollars.The swap rate is the difference between the repurchase (resale) priceand the original sale (purchase) price. The swap rate and the spot ratetogether implicitly determine the forward exchange rate.The third category of foreign exchange transactions are outrightforward transactions. These are current agreements on the price, quan-