Question

Does Arbitrage Destabilize Foreign Exchange Markets?

POINT: Yes. Large financial institutions have the technology to recognize when one participant in the foreign exchange market is trying to sell a currency for a higher price than another participant. They also recognize when the forward rate does not properly reflect the interest rate differential. They use arbitrage to capitalize on these situations, which results in large foreign exchange transactions. In some cases, their arbitrage involves taking large positions in a currency, and then reversing their positions a few minutes later. This jumping in and out of currencies can cause abrupt price adjustments of currencies and may create more volatility in the foreign exchange market. Regulations should be created that would force financial institutions to maintain their currency positions for at least one month. This would result in a more stable foreign exchange market.

COUNTER-POINT: No. When financial institutions engage in arbitrage, they create pressure on the price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing discrepancies would become more pronounced. Consequently, firms and individuals who use the foreign exchange market would have to spend more time searching for the best exchange rate when trading a currency. The market would become fragmented, and prices could differ substantially among banks in a region, or among regions. If the discrepancies became large enough, firms and individuals might even attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a more integrated foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line with the market.

WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

Answer 1

The arbitrage can be coined as an act of buying an asset from a market with low cost and selling the asset in another market with higher cost.

NOTE: Arbitrage opportunities are available to any individual or firm because the price of the same asset is different in two different markets and speculators take advantage of it.

For instance:

Let assume than an individual person is involved in trade of USD. He buys USD from a cheaper market and sell its in a higher market to make profit from it.

According to me, the counter point is complete right in the following case. Arbitrage shall remove any price differences and make the price same in different markets. Basically, large financial companies involved in the stock market have technical software and algorithms which are done on the basis or data science and data analyst using statistical approach which try to identify arbitrage opportunities using this software. The main work of this software is to find difference in price of two different currencies. The trader company shall use the difference by buying the product at a lower rate from cheaper market and selling the product in expensive market. Over here, the law and principles of demand and supply shall govern. If the arbitrage traders buy the asset from the cheaper market, the demand of the currency shall increase. As a rule of economics, if the demand of the asset or currency increases the price shall increase automatically. On the other hand, if we sell currency in expensive market, the supply shall increase. As a rule of law of supply, if the supply increase, the price of the currency decrease.

This totally leads us to a conclusion. That the price in lower market shall increase and the price in expensive market shall decrease because of changes in demand and supply due to arbitrage. This leads to price equilibrium in two different market and makes the price more even. Because of price equilibrium, the prices are same in all the market in the long run. So any individual person, firm or company related to finance can buy the currency from any market at the same price. Neither a higher price nor a lower price but constant price because of arbitrages. This is a benefit as the purchaser of currency doesnt have to research on the optimum point of buying the currency but it is already available at a fair market price which an purchaser can buy without any study, research or anything.

So i totally agree on the contrary viewpoint. Arbitrage removes market price difference between two different prices of the same currency. In an additional point, traders are also involved in triangular arbitrage to see the possibility of price difference in 3 different currencies. For example, a financial institution using the USD, EUR, and GBP to observe the difference in price and taking advantage of it. So eventually, using different methods of arbitrage by financial participants it is hard to find out difference in price as they would become even in the long run.