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Spatial Arbitrage
Spatial Arbitrage refers to buying a currency in one market and selling it in another. Price differences arise from geographical (spatial) dispersed markets. Due to the low-cost rapid-information nature of the foreign exchange market, these prices differences are arbitraged away quickly.
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Triangular Arbitrage
Triangular arbitrage involves a third currency and/or market. Arbitrage opportunities exist if an observed rate in another market is not consistent with a crossrate (ignoring transaction costs). Again, profit opportunities are likely to be arbitraged away quickly, meaning that crossrates are, for the most part, consistent with observed rates.
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Example Continued
A trader with $1, could buy 0.687 in New York. The 0.687 would purchase b57.274 in London. The b57.274 purchases $1.375 in New York, or 37.5% profit on the transaction. To understand the arbitrage opportunity, remember buy low, sell high.
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Example: Continued
Suppose in 1996 the British CPI was 156.4 and the US CPI was 154.7. In 2000, the CPIs were 170.5 and 172.7 respectively. Based on this, British prices rose 9.0 percent while US prices rose 11.6 percent, a 2.6 difference. Since the prices of British goods and services rose slower than the prices of US goods and services, there was an increase in purchasing power of British goods and services relative to the purchasing power of US goods and services.
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Conclusion
The nominal exchange rate change resulted in a 5.2 percent gain in the purchasing power of UK goods and services for US residents. The difference in price changes resulted in a 2.6 percent gain in purchasing power of UK goods and services relative to US goods and services for US residents. Note how the 5.2 percent decline was augmented by the 2.6 gain, resulting in an overall 7.7 percent gain in purchasing power.
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Weights
Suppose that of all the trade of the US with Canada, Mexico, and the UK, Canada accounts for 50 percent, Mexico for 30 percent, and the UK for 20 percent. These constitute our weights (0.50, 0.30, and 0.20). Now consider the following exchange rate data.
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Example
Let last year be the base year. The effective exchange rate last year was:
[(1.52/1.52)*0.50 + (10.19/10.19)*0.30 + (0.61/.61)*0.20]*100
= 100. As with any index measure, the base year value is 100.
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Example
Todays value of the EER is:
(1.44/1.52)*0.50 + (9.56/10.19)*0.30 + (0.62/0.61)*0.20
or (0.958) 95.8 The dollar, therefore, has experienced a 4.2 percent depreciation in weighted value.
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180
120
100
United Kingdom
80 Japan 60
40
20
0
80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 19 00 20
S0 S1 Demand
Q0
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Important Note
It is vital to construct and label supply and demand diagrams properly. Note here we are diagramming the market for the euro. Hence, it is crucial to represent the correct exchange rate on the vertical axis. The correct exchange rate is one that reflects the price of the euro. That is, it must be an indirect quote.
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An Increase in Demand
Consider an increase in the demand for the euro. Suppose, for example, that savers desire eurodenominated financial assets relative to dollar-denominated financial assets because of a change in economic conditions. The demand for the euro rises as savers desire more euros to purchase greater amounts of European financial assets.
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S0
Demand Q0
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S1
S0
Q0
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Equilibrium
The market is in equilibrium when the quantity supplied of a currency is equal to the quantity demanded. This is the market clearing exchange rate because there is no surplus or shortage of the currency.
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Equilibrium
S ($/) S
S0
D Q0
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S1
S0 D Q0
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S* S0 D Q0
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Undervalued
In the previous slide, the euro is said to be undervalued. The predicted or expected spot rate, S*, lies above the market determined rate, S0. Hence, it should take a greater amount of dollars to buy each euro. The euro, therefore, is underpriced, or undervalued.
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Suppose The Economist magazine sells for 2.50 in the UK and $3.95 in the US. Arbitrage, therefore, should guarantee that the exchange rate between the dollar and the pound be s = 3.95/2.50 = 1.580 ($/). In words, the dollar price of The Economist in the UK should equal the dollar price of the Economist in the US (ignoring transportation costs).
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Absolute PPP
Absolute PPP is expressed as P = P*S, where P is the domestic price, P* is the foreign price, and S is the spot rate, expressed as domestic to foreign currency units. Often it is rearranged as: S = P/P*.
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Example
Suppose the exchange rate between the dollar and the pound was 1.58 in 1999 and is 1.60 today. Further, the UK CPI was 110 and is now 115, while the US CPI was 108 and is now111. Plugging this into the formula we have st = (1.58)[(111/108)/(115/110)] = 1.55 Hence the is overvalued (3.125%).
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Another Expression
Often economists will take the log of the previous expression of RPPP to obtain the following. - * = S In words, domestic inflation less foreign inflation should equal the change in the spot rate. Implies that the higher inflation country should see its currency depreciate.
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