Meaning:
The term arbitrage refers to the purchase of a currency in that financial centre where it is cheaper for immediate resale in another centre where it is relatively expensive so as to make a profit out of this two-step deal.
Scope:
The scope for such a profitable deal exists if the rate of exchange, at two financial centres, between two currencies, is inconsistent. Such a situation is also known as one of indirect or cross rates inconsistency, and it may exist between more than two currencies and at more than two financial centres.
Illustration. Let us assume that in New York, dollar-rupee exchange rate is $ I = Rs.40, while in London, the pound-rupee rate is£ 1 =Rs. 75; and pound-dollar rate is£ 1 =$ 1.75.
Then, it would pay an Indian to sell rupees and buy dollars in New York, sell dollars in London and buy pounds and then sell pounds in London and buy rupees.
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For example, if the Indian starts by selling Rs. 280,000 in New York, he gets $ 7,000, which will fetch him £ 4,000 in London which can be exchanged for Rs. 300,000, thus yielding him a profit of Rs. 20,000.
Effect:
Arbitrage wipes out any cross rate inconsistency because the demand for each currency increases at the centre where it is cheaper and declines in the centre where it is expensive. This process of arbitrage continues till the rate difference is wiped out. Only early birds get the worm.
Arbitrage acts as a stabilising influence; particularly because these days international financial transactions can be conducted at a very low cost and with small profit margins.
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This device brings about an integration of the worldwide foreign exchange market, because the movement of funds has become highly sensitive to even small changes in exchange rates.
Arbitrage is usually practised by banks and other big financial institutions where the amount of profit depends more upon the turnover than upon the profit margin as such.
Arbitrage also works to iron out interest rate differentials on financial investments. Short term capital is particularly attracted to the prospects of higher interest rate earnings.
More precisely, there is an inherent tendency for ‘yield’ on different securities to be equated, where ‘yield’ is taken to mean interest income plus capital gains or loss, as the case may be.
Relevance:
It may be noted that forward exchange market and arbitrage have relevance only when there is exchange rate flexibility, though it need not mean full-fledged ‘floating’ of the currencies.
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Arbitrage is not possible under exchange control wherein it is not permitted to transfer funds from one country to the other without official permission and beyond the amounts sanctioned.
In such cases, to the extent exchange control is not administratively effective, unofficial (or black market) transactions may develop to take advantage of differences in exchange rates.