How the concept of arbitrage can generally be used to explain exchange rate movements?

Expert Solution

Arbitrage is the primary concept which drives the movements in exchange rates all over the world. Suppose consider that due to some reason, the USD depreciates. So, if earlier you could buy 1 Euro for 1 USD, now you can buy 1 Euro for 2 USD (hypothetical). Now, because of this what will happen is that the other currencies, being the same in value as before, their exchange rate with respect to the USD has to change in order to keep their exchange rate with respect to Euro constant. Ande, we can understand that the exchange rate between Euro and the other currency (say INR) has to stay constant because their is no change in either of their values. So, suppose we think that the change of Eur-USD exchange rate to $2/EUR has no change in the other exchange rates. If their is no change then what arbitrageurs and other market participants will do is that they will make use of this changed rate in order to profir as the rate between Eur and INR and INR and USD has remained same. This will result in arbitrage gains to them which will slowly disappear as more and more people will get to know it and slowly the exchange rate between the INR and USD will change.

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