Does arbitrage destabilize foreign exchange markets

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Reference no: EM13208130

Discuss the following topic: "Does arbitrage destabilize foreign exchange markets?" Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices by making a riskless profit. In many cases, the strategy does not require an investment of funds to be tied up for a length of time and does not involve any risk. The act of arbitrage will cause prices to realign. Basically, there are three types of arbitrage:

1. Locational arbitrage,

2. Triangular arbitrage, and

3. Covered interest arbitrage.

The threat of locational arbitrage ensures that quoted exchange rates are similar across banks in different locations. The threat of triangular ensures that cross exchange rates are properly set. The threat of covered interest arbitrage ensures that forward exchange rates are properly set. Any discrepancy will trigger arbitrage, which should eliminate this discrepancy. Thus, arbitrage should allow for a more orderly foreign exchange market. Others, however, argue that the act of arbitrage itself will result in more instability in the foreign exchange market.

Instructions:
1- To read the point and counter-point of this argument and express your own opinion on this topic :

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 currency and then reversing their position 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. That 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 become 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.

Reference no: EM13208130

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