Show how arbitrage opportunities disappear in foreign exchange rate markets. Use a graph in your explanation...

Show how arbitrage opportunities disappear in foreign exchange rate markets. Use a graph in your explanation (supply and demand). please try if do not understand still please.!

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Expert Solution

Arbitrage implies taking advantage of price differences in same financial instruments.The most important rule to make money is to buy at low rates and sell at high rates.Arbitrage opportunities arise in different derivatives market. This means that a person may find different exchange rates on forward and future contracts and take the opportunity.

As for eg if the September future for Mexican Peso is $ 0.08 while the forward contract is $0.084, there is a difference in the dollar price of Mexican Peso.So Pesos can be brought at a lower price and sold at a higher price.So profit can be made .As Pesos are being purchased in future contracts , the dollar price of Pesos increase.Again as Pesos are sold on forward contract , the dollar price of Pesos decrease.This goes on until the dollar Mexican Peso Exchange rate is the same and no arbitrage exist.

In the graph , the demand for dollar shifts to the right while the supply of dollar shifts to the left.,and the new equilibrium has a stronger exchange rate.

Rahul Sunny answered 11 months ago

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