Arbitrage is the process that ensures that all exchange rates are mutually consistent. If for example, one US dollar exchange for one Canadian dollar, and one Canadian dollar exchange for one British pound, then the US dollar-pound exchange rate should be one pound for one dollar.
image source: c1.staticflickr.com
If it differs, then there is an opportunity to make profit. The process of arbitrage is exactly that of finding and exploiting profitable opportunities in exchange rate inconsistencies between markets However, as a result of triangular arbitrage, inconsistencies will be eliminated rapidly.
ADVERTISEMENTS:
Cross rates, however, will only be roughly consistent given the bid-ask spread associated with transaction costs. I n recent years, such opportunities for profit making have been greatly reduced by high-speed, computerized information systems and the increased sophistication of the banks operation in the market.
Arbitrage of a slightly different kind result from price differences in different locations. This is space arbitrage. For example, if sterling were cheaper in London than in New York, it would be profitable to buy in London and sell in New York.
Similarly, if exchange rates in the interbank market differed from those at the IMM it would be profitable to arbitrage between them. As a result of this activity, prices in different locations will be brought broadly into line.
Interest arbitrage is slightly different in nature from triangular or space arbitrage; however, the basic motive of finding and exploiting profitable opportunities still applies. Interest rate being the cost of borrowing or the return to lending for a specific period of time will be different for different currencies.
ADVERTISEMENTS:
However, real returns on assets of similar quality should be the some of the exchange rate risk is covered or hedged in the forward market. This result is known as covered interest parity. It holds more- or-less exactly, subject only to a margin due to transaction costs.