Question

  Explain in your own words what is meant by the phrase “arbitrage in financial markets”. Specify how it relates to both interest rates and exchange rates.

Answer 1

Arbitrage in financial markets is refered to as earning higher than risk free rate while taking no risks.

Suppose risk free rate is 2%, arbitrager will be able to earn higher than 2% without taking any risk.

It can be related to interest rates and exchange rates, using interest rate parity.

Suppose, you borrow some amount from US at 2% interest rate. Then, you convert it into INR and invest in Indian government bonds yielding 6%. This might seems to be an arbitrage first. But, think about the exchange rates. After one year, you will receive INR proceeds with a growth of 6%. Then you will have to repay in USD. Till this period the exchange rate should have depreciated INR by around 4%, so that there is no arbitrage. This is the concept of interest rate parity which is based on no arbitrage princple.

Now, arbitrage opportunity can be found in the market, if forward exchange rates are not priced according to spot exchange rates and interest rates. If forwards are undervalued as compared to interest rate parity then taking a long(buy) position in forward and short(sell) in spot will create arbitrage opportunity.

Similarily, if the forwards are overvalued as per interest rate parity then taking a short(sell) position in the forward and long(buy) position in spot will create arbitrage opportuity.