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Chapter 11: Problem 4

Explain why exchange rate quotations stated in different financial centers tend to be consistent with one another.

Short Answer

Expert verified
Exchange rate quotations in different financial centers tend to be consistent due to the influence of arbitrage. Divergence in exchange rates across markets would create opportunities for profit by buying cheaply in one market and selling at a higher rate in another, and this process would soon push the rates back towards an equilibrium level.

Step by step solution

01

Understanding the Role of the Foreign Exchange Market

The Forex market functions to enable the exchange of one currency for another and to determine the relative value of one currency vis-à-vis another. The rate at which this exchange takes place is called the exchange rate.
02

Unpack the Concept of Arbitrage

Arbitrage is the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms, taking advantage of differing prices for the same asset. In an efficient market, prices should align or else arbitrage opportunities would exist.
03

Apply Arbitrage to Exchange Rates

If exchange rates differed significantly between countries, this would present an arbitrage opportunity. Traders could buy a currency cheaply in one market and sell it for a profit in another where its value is higher. But this buying and selling would eventually push the prices back towards alignment, creating a tendency for exchange rates to be consistent with one another across different financial centers.

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Most popular questions from this chapter

Distinguish between stabilizing speculation and destabilizing speculation.

Suppose \(\$ 1.69=£ 1\) in New York and \(\$ 1.71=£ 1\) in London. How can foreign exchange arbitragers profit from these exchange rates? Explain how foreign exchange arbitrage results in the same dollar/ pound exchange rate in New York and London.

Who are the participants in the forward exchange market? What advantages does this market afford these participants?

The supply and demand for foreign exchange are considered to be derived schedules. Explain.

What is the strategy of speculating in the forward market? In what other ways can one speculate on exchange rate changes?
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