by a random chaosboy

Created on: January 20, 2007   Last Updated: April 13, 2007

The world's currency market fascinates experts and amateurs alike. For traders it is the grandest of the arenas in which economic theory and policy play out in the harrowing daily drama unique and ubiquitous to financial markets. To the more casual observer, a safe distance from any theory that might make sense of what's going on, currencies can seem almost netherworldly, foreign to conventional notions of the value of things. Indeed, international macroeconomics is complex enough so that there isn't a singular, complete theory fully explaining everything that happens. Instead, market observers and participants have to understand the different forces that influence exchange rates generally, and ascertain for themselves which ones will be operative under the given circumstances and how and why. The most important of these forces are arbitrage, trade, investment, and monetary policy.

Arbitrage is a concept in finance describing how certain relations between the prices of different things, will hold in the market when it is possible to execute certain trades exchanging those things. Arbitrage does for the financial markets what the structural grid of a building does for its form, or what our facial bones do for our appearance. In the currencies markets it is manifested in the concepts of purchasing power parity and interest rate parity, and its power in the market is readily illustrated by example:
Assume that 1 pound Sterling can be bought or sold in the market for $2 for delivery immediately, $2.10 for delivery a year out. Assume also that you can borrow or lend in Britain at 15%, and borrow or lend in the United States at 10%. Then with these facts you should immediately borrow $2 at 10%, buy a pound, invest it at 15%, and sell the future value back a year out at the $2.10 price. In a year you will have 1.15 pounds, which are worth $2.415, and your debt will be due for $2.2. So you will have made $.215 for free.
The elements of the arbitrage trade were (1) simultaneously, (2) taking offsetting positions, (3) at a profit. However, in executing your arbitrage you cleared a certain amount of volume out of the market at those prices, and the volume remaining to be traded will be at prices offering a slightly leaner arbitrage - and so on as you keep repeating the trade, until it is gone. When prices are in relation so that there are no available arbitrages, they are said to be in parity. This illustration was an example of interest rate parity; purchasing power

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