Question

What is arbitrage? Discuss how arbitrage would work in the spot market if E$/£ is higher in New York City than in London. State the no-arbitrage (equilibrium) condition for the spot market between the two currencies at the two different locations (define symbols).

Answer 1

The arbitrage is a condition of the market anomaly. That is according to the law of one price, an asset should be priced at the same rate in every market or if the two assets are similar in each aspect then their price should also be similar.
If this condition is not met then there could be a mismatch between asset prices and there is a riskless profit in the market.
Traders or speculators will sell an asset in the higher priced market while buying it in a lower priced market. The law of one price will bring the price of that asset to the same level and traders will profit from this situation.
This is called arbitrage trade.

If the $/£ rate is higher in New York than in London then this is an arbitrage opportunity. The traders will sell $/£ in the New York market will simultaneously buy that in the London market. The market forces will drive down the rate in the New York market while pushing up it in the London market. The traders will gain until it reaches the same level in both the market where no arbitrage is possible.

The no-arbitrage condition is the scenario where the asset is priced similar in any market where it trades and there is no mispricing. Suppose that Euro to $ is currently trading at 1.12 in the Singapore market. Now according to the law of one price the rate for Euro to Dollar should be the same in any other market ignoring transaction cost. Similarly, the Dollar to Euro price should be ( 1/1.12 = 0.89) in other markets again ignoring transaction costs. This is a no-arbitrage condition because all the assets are priced at the same level and there is no riskless profit.