Arbitrage Destabilizes the Foreign Exchange Markets - Example

ARBITRAGE IN THE FOREIGN EXCHANGE MARKET Name: Institution affiliated: Date of submission: Tutor: Introduction The study is done to determine which between the two arguments provided in true on the question of whether arbitrage destabilizes the foreign exchange markets. The major argument points provides are that one supports that arbitrage destabilizes the foreign exchange markets while the other is of a contrary opinion. According to the first argument, the large financial institutions easily recognize when the rate do not reflect the proper interest rates differentials since they have the technological capacity to identify unique activities of each individual participant in the foreign exchange market. Argument that support the that arbitrage destabilizes the foreign exchange market show that the jumping in and out of currencies can cause changes in prices adjustments thereby creating a volatile foreign exchange market. The counter point provides that when the large financial institutions engage in arbitrage, pressure in the prices of currency in created thus removing any discrepancies in the pricing of the stock in the market. If this is not done and the discrepancies become large enough the individuals and firms are usually force to conduct arbitrage in the market themselves. Empirical studies conducted on the issue of arbitrage will help determine which of the above issues is true about the foreign exchange market. The study is investigative as it tries to identify whether arbitrage destabilizes the foreign exchange markets. The foreign exchange market provides individuals, banks, firms and other major organizations with a platform for buying and selling the foreign currencies. The foreign exchange markets provide a number of major functions in every given economy some of them include; the transfer of funds from one nation or from one currency to another. The levels of transactions for the transfer of funds are usually four namely; central bank, foreign exchange brokers and traditional users. The first level is the traditional users and includes participants like importers, exporters, tourists and investors. The commercial banks and foreign exchange brokers provide second level and third level fund transfers which include the wholesale and interbank markets. Finally, the central bank is usually vied as the lender of last result. The demand for the foreign currency is usually driven by the transactions that usually require the foreign currency to be available in the market. The major demand drivers are the assets flows to countries that are abroad and imports. The financial markets usually assume efficiency in the markets. The potential lenders and borrowers in the financial markets provide continuous information to the financial markets on how to rule out the arbitrage opportunities that exist in the market. The financial markets theory is usually based on the law of asset prices. In the international financial markets, the domestic interest rates are usually equal to the foreign lending rates the assets that are the same in the market. The violation of the law brings about arbitrage in the market [Jef14]. Arbitrage is the profits made from the temporary differences in prices in the market. It entails the buying of shares in one market and simultaneously selling them to another one in the market. Microstructure theory Arbitrage is a fundamental factor in the financial economies of the world. There has been an acceptance that the financial markets cannot provide a risk free arbitrage opportunity since there are always transactional costs involved in buying and selling securities in the market. If arbitrage is not observed in the market, the market may not provide enough incentives to the consumers of the products to watch the movements of the markets. To increase the incentives provided, the major determinants of the market activities should provide short term arbitrage opportunities in the market after which they should eliminate them almost immediately. The theory also identifies that where the market is not fully centralized the imperfect market may provide different prices to the same assets in the same market. Although the theory identifies that the market needs to offer short term arbitrage opportunities in the market as incentives for the participant to participate fully in the market, research has not been successful to provide means through which the market can create and detect short term arbitrage opportunities in the different financial markets. The major shortcoming that arises and makes the detection difficult is that there is a very high level of activity in the major world financial markets, yet the short term arbitrage opportunities that may arise in the market require real time quotations of the asset prices which has proved almost impossible to achieve. It is important to recognize that the funds in the stock exchange markets are lent out or borrowed at different market interest rates which make the market to have risk activities. It is for this reason that arbitrage cannot be avoided in the market. The microstructure theory has also identified that the control of arbitrage is equally almost impossible. Thus the traders need to understand the market before they can engage in the purchase and sales of shares in the foreign market. The case being studied is whether arbitrage opportunities usually destabilize the foreign exchange market. According to the microstructure theory, it is hard to control the market and therefore, the arbitrage opportunities are likely to be adamant in such markets. Since the large companies have the ability to identify any instance of irregularity in the market due to the advanced technologies that they have, the can identify instances of arbitrage in the market. When an individual takes up the arbitrage opportunities that arise in the market, the large companies easily identify the move but such a move is not likely to trigger any major effect in the foreign market. However, when many traders in the market take up arbitrage opportunities in the market, a crisis is likely to erupt in the market. the stability of the foreign market is likely to be compromised as the traders continuously engage in the selling and purchasing of securities in the foreign market. the major problem will be that as the traders sell their securities to make fast profits, the market ends up on the losing end as the prices of the securities are likely to deteriorate thus discouraging the stock market activities in the foreign markets. Arbitrage and liquidity The inefficiencies in the financial markets usually have major effects in the economy. Theoretically, the impact of arbitrage on liquidity is usually reliant on the reasons for the rise of the arbitrage. In as much as liquidity of the financial markets encourages arbitrage activities to be undertaken, there is real reasons that provide evidence that arbitrage also impacts the liquidity of the financial markets. It is therefore, true that the two are interrelated and that each of the factors depends on the other in the financial markets. According to Gromb and Vayanos, (2010) the arbitrage that rises due to the demand stock such as sales from mutual funds increseas the market capacity and thus improves the liquidity of the financial markets. However, in the instances that arbitrage rises from the different sets of informationthe markets liquidity might deteriorate. The arbitrage could therefore provide a prediction to the liquidity of the market [Gro10]. The liquidity in the foreign markets is available when the traders in the market reduce the instances of purchasing long term securities and start to engage in the purchase of short term securities. The trader take this move as they anticipate that instabilities are likely to happen in the foreign markets thus they keep their funds as liquid as currently possible while at the same time trying to invest to make their personal profits. The arbitrage opportunities thus lead to the creation of liquidity in the foreign market since there are no long term investments made by the traders. The purchase of long term securities in the market like bonds and bids are highly evaded and for this reason, the liquidity brings instability in the foreign market as traders reduce their investments in long term securities. Rates and costs The transactional costs in the buying and selling of securities are a major determinant of the financial activities of the financial market. Among the transactional costs in the foreign exchange markets are brokerage fees and settlement costs. The settlement costs are incurred by both the one purchasing the securities and the one selling the securities. The brokerage fees are the fees paid to the aggressor who is usually the initiator of the securities trading activity. The interest rates are also major determinants of the arbitrage activities that may arise in the foreign exchange market. The higher the interest rates provided by the foreign exchange market, the lower the arbitrage opportunities that the trader will take as they will prefer to invest in long term securities to earn the interest high interest in growth of the market. However, when the interest rates are lower, the traders will be encouraged to take up arbitrage opportunities that may arise in the market [Pay03]. In any foreign exchange market, depending on the rates and transactional costs that exists in the market, the major opportunities will be to take up the arbitrage opportunities in the market or hedging. The determinants of the arbitrage opportunities in the market are the interest rates and transactional costs. Traders usually take up the arbitrage opportunities when the interest rates provided by the foreign exchange markets are usually low thus discouraging investment activities in the market. Similarly, when the transactional rates are lower, the traders are encouraged to take up arbitrage opportunities that arise in the market. Since the traders take up arbitrage opportunities due to the easy profits that they fetch, the lower rates will encourage them to purchase and sell the securities often as they will make more profits [Osc00]. Hedging is an action of the traders to avoid the foreign exchange risks and thus the traders avoid the buying and selling of securities as they anticipate their funds will earn interest in the long term investment. The act is common when the interest rates are high and the transactional costs are equally high. Taking up arbitrage opportunities in such a market will create losses to the trader and thus will be discouraging to the investors to take up such investment. Rather, the investors will likely invest in the long term securities like bids and binds. The rates and costs thus also determine the stability of the foreign exchange markets from the arbitrage opportunities that arise in the same market. When the interest rates are low and the transactional costs are equally low, the traders will likely take up the arbitrage opportunities in the market. In such a case, the trader will avoid long term investments in the market. Similarly, when the interest rates are higher and the transactional costs are equally high, the traders will most likely prefer the long term investment in the market. With most traders opting for long term investments, there will lack liquidity in the market as the short term investments will not be available. This will in turn also create instability in the market thus supporting the issue that arbitrage opportunities create instability in the foreign exchange market. Conclusion In conclusion, a number of factors have been identified to determine the rate at which arbitrage opportunities are created and taken up by traders in the market. The study has identified the three major determinants of arbitrage in the foreign exchange market as liquidity, financial economies of the world and rates and costs in the market. Each of the fundamental factors determines the activities of the traders in the foreign exchange markets. The major decisions made in such markets are usually reliant on the three major factors. Arbitrage is usually highly affected by the three factors. Each of the factors determines helps the traders to decide whether to purchase or sell their securities or to invest in other long term securities like the bonds. The factors help the traders to speculate the market activities and thus make rational decisions in their investments. REFERENCES Jef14: , (Jeff, 2014, pp. 247-248), Gro10: , (Gromb & Vayanos, 2010), Pay03: , (Payne, 2003), Osc00: , (Oscler, 2000), Read More