EXCHANGE RATE BEHAVIOR

Exchange Rate Behavior

Exchange Rate Behavior

Question 1)

Mere existence of triangular arbitrage opportunities does not necessarily imply that a trading strategy seeking to exploit currency mispricings is necessarily profitable. Electronic trading systems allow the three constituent trades in a triangular arbitrage transaction to be submitted very rapidly. However, there exists a delay between the identification of such an opportunity, the initiation of trades, and the arrival of trades to the party quoting the mispricing. Even though such delays are only milliseconds in duration, they are deemed significant. For example, if a trader places each trade as a limit order to be filled only at the arbitrage price and a price moves due to market activity or new price is quoted by the third party, then the triangular transaction will not be completed. In such a case, the arbitrageur will face a cost to close out the position that is equal to the change in price that eliminated the arbitrage condition.

Question 2)

Covered interest arbitrage is feasible. Frankel and Levich (1975) tested the parity condition in terms of transactions costs. They used triangular arbitrage (as an equilibrium condition) to estimate the costs of transactions in the foreign exchange market and the bid-ask spread to measure the transactions costs in the money markets. They defined a neutral band around the interest parity line within which no arbitrage is profitable. They found that transactions costs explained almost all the deviations from the interest parity line; few were outside the neutral band. They added that the existence of elasticities of demand and supply in the securities and the foreign exchange markets which are less than infinite will widen the neutral band and will account for an even greater percentage of the deviations from the line. Deardorff (1979), also analyzed interest parity in terms of transactions costs ...