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# Exchange Rates and Arbitrage - PowerPoint PPT Presentation

Joel Graham Joe Griner. Exchange Rates and Arbitrage. Outline. What are Exchange Rates? Purchasing Power Parity History – Exchange Rate Systems Big Mac Index Cross Rates Triangular Arbitrage. What are Exchange Rates?.

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Joel Graham Joe Griner

### Exchange Rates and Arbitrage

• What are Exchange Rates?

• History – Exchange Rate Systems

• Big Mac Index

• Cross Rates

• Triangular Arbitrage

• The amount of currency that can be exchanged for a unit of another currency

• \$1 us = ¥95

Shoe

Japan USA

¥7,000 S&H\$70.00 S&H

Exchange Rate?

\$1 = ¥100

• This establishes the concept of purchasing power parity, a single product should be the same priceboth countries

• Is this assumption always true?

• Whatcouldcause prices to be different?

• Economic Climate

• Government Policy

• Inflation

Shoe

Japan USA

¥7,000 S&H\$70.00 S&H

6% -- Inflation -- 3%

What is the new price?

¥7,420 S&H \$72.10 S&H

Exchange Rate?

\$1 = ¥102.91

Forward Rate = Spot Rate x ( (1 + πfc) ÷ (1 + πdc) )

• Represents the real value of the currency within the country

• PPP suggests that two different currencies should adjust so that items cost the same in both countries

• Such adjustments occur through inflationary forces, causing the price of goods in one country to be higher than in the other

• When this occurs, exchange rates must change in order to reflect the change in purchasing power between the two currencies

• The gold standard

• Bretton Woods

• Fixed Exchange Rates

• End of Fixed Exchange Rates

The Gold Standard

• For centuries the world’s currency was backed by gold.

• In the 1930s, the US dollar was set to a fixed rate of 1 ounce of gold being worth 35 dollars.

• The gold standard finally broke down in 1971 do to unstable governmental policies as well as high inflation.

• Held in Bretton Woods, New Hampshire in July 1944.

• The 44 allied nations met to discuss international monetary policies.

• Created a pegged exchange rate that made the dollar as the reserve currency.

• Countries pegged their currency against the US dollar which made the US dollar the reserve currency.

• The US dollar was convertible into gold.

• Countries were required to keep their exchange rate within +/- 1% of parity.

• US was spending too much on the Vietnam War and social programs and the dollar was becoming way undervalued.

• Too much gold was being exchanged for dollars which decreased the amount of gold in the US

• In 1971, Nixon declared that dollars were no longer convertible to gold, which led to the establishment of the floating exchange rate system.

• Since the purchasing power parity concept can be complex and difficult to measure, The Economist established a way to measure real-world PPP using MacDonald’s Big Mac hamburger

• The Big Mac was chosen because of it’s availability in many countries around the world and the ability of franchisees in establishing input prices

• The Big Mac PPP exchange rate is calculated between two countries by dividing the price of a Big Mac in country A by the price of a Big Mac in country B.

• The Big Mac exchange rate is then compared with the actual market exchange rate

• If the calculated rate is lower, then the currency is undervalued, if higher, than it is overvalued

• It is effective in measuring PPP because it is a consistent good, with very few differences across countries

• A simple basket of goods can vary greatly by culture, as basic goods defined here in the U.S are significantly different than those in other parts of the world such as in rural India

• Big Mac Index: Feb 4th, 2009

• A direct quote is expressed as x amount of home currency units = one foreign currency unit

• For example: \$0.85 = €1

• An indirect quote is simply the reciprocal of a direct quote, expressed as x amount of foreign currency units = one home currency unit

• For example: ¥120 = \$1

• Quoting in terms of home currency (U.S. Dollars) per unit of foreign currency is called American Terms

• Quoting in terms of # of foreign currency units per unit of home currency (U.S. Dollar) is called European Terms

• \$.20 = ¥1 American Terms

• ¥5 = \$1 European Terms

• The exchange rate between two countries other than the home country can be inferred from their exchange rates with the home currency

• Rates calculated in this way are referred to as theoretical cross rates

• c\$ / \$ x € / c\$ = € / \$

X

=

0.698798 Euro to 1 USD

• If 0.698798 ≠ the reported Euro to USD exchange rate, an arbitrage opportunity exists

• Barring any government restrictions, riskless arbitrage will assure that the exchange rate between two countries will be the same in both countries

• In reality, theoretical cross rates computed from exchange quotes, rarely differ from the actual cross rates quoted by dealers

• In the event that an imbalance occurs, a riskless arbitrage opportunity arises

\$

€ c\$

Beginning with 20,000 USD

20,000 USD

13975.96494 Euro ÷ 0.698798 USD per Euro

13975.96494 Euro

\$

€ c\$

Beginning with 20,000 USD

20,225.02165 USD

13975.96494 Euro ÷ 0.690000 USD per Euro

Risk Free Profit of \$225.022

13975.96494 Euro