International Arbitrage and Interest Rate Parity

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Within the foreign exchange market there are times where currency prices are misquoted. The misquoted prices can lead to an inaccuracy within the foreign market exchange. However, the market will readjust itself by international arbitrage which is the act of capitalizing on the divergence of misquoted prices by creating a riskless profit. Arbitrage is a strategy that investors use to not have to make an investment which includes no risk or funds being tied to a certain asset. There are three forms of international arbitrage: location arbitrage, triangular arbitrage and covered interest arbitrage. Location arbitrage is a process where a participant of the foreign exchange can go to one place, bank in a specified location, to purchase a currency at a lower price and then sell it to another location where the currency is priced higher. The prices of currencies are roughly the same; however, at times currency in one place can sell for more or less than in another place based on the supply and demand for the specified currency. This is the window of opportunity where arbitragers can immediately purchase the currency in one place and sell it to another before market forces naturally realign the prices. The act of location arbitrage is a way to readjust prices so that they are once again equal in all places. However, due to the advancement in technology within the exchange market, it is very difficult to use this process since computers are able to detect currency discrepancies. Triangular arbitrage is used by the discrepancy of prices within cross exchange rates which is the relationship between two currencies that are different from one’s base currency. If the cross exchange rate is less than the actual cross exchange rate of two currencies of the base currency, triangular arbitrage can be used in the spot market to capitalize on the difference. The greater the bid/ask spread the higher the profit from using triangular arbitrage. The impact of triangular is as...
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