A Beginner's Guide to Exchange Rates and the Foreign Exchange Market  
[Part 2: Exchange Rates  Arbitrage] 

Suppose the Algerian dinarstoBulgarian leva exchange rate is 2. We would expect then that the BulgariantoAlgerian exchange rate would be 1/2 or 0.5. But suppose for a second that it wasn't. Instead assume that the current market BulgariantoAlgerian exchange rate is 0.6. Then an investor could take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 Bulgarian leva and exchange them back for Algerian dinars. At the BulgariantoAlgerian exchange rate, she'd give up 10 leva and get back 6 dinars. Now she has one more Algerian dinar than she did before. This type of exchange is known as arbitrage. Since our investor gained a dinar, and since we're not creating or destroying any currency, the rest of the market must have lost a dinar. This of course is bad for the rest of the market. We would expect that the other agents in the currency exchange market will change the exchange rates that they offer so these opportunities to get exploited are taken away. Still there is a class of investors known as arbitrageurs who try to exploit these differences. Arbitrage generally takes on more complex forms than this, involving several currencies. Suppose that the Algerian dinarstoBulgarian leva exchange rate is 2 and the Bulgarian levatoChilean peso is 3. To figure out what the AlgeriantoChilean exchange rate needs to be, we just multiply the two exchange rates together: AtoC = (AtoB)*(BtoC) This property of exchange rates is known as transitivity. To avoid arbitrage we would need the AlgeriantoChilean exchange rate to be 6 and the ChileantoAlgerian exchange rate needs to be 1/6. Suppose it was only 1/5. Then our investor could again take five Algerian dinars and exchange them for 10 Bulgarian leva. She could then take her 10 leva and get 30 Chilean pesos at the BulgariantoChilean exchange rate of 3. If she then exchanged her 30 Chilean pesos at the ChileantoAlgerian rate of 1/5, she'd get 6 Algerian dinars in return. Once again our investor has gained a dinar and the rest of the market has lost one. For any three currencies A, B, and C, trading A for B, B for C and C for A is known as a currency cycle. The AtoC exchange rate not only places restrictions on the CtoA exchange rate, but it also places restriction on the AtoB and BtoC pair of exchange rates. Most of the time all the exchange rates on the market will be synchronized like this, but occasionally they'll become out of sync and arbitrageurs can make a profit from currency cycles. The relative prices of currencies are not set just to ensure that profitable currency cycles do not exist. Arbitrageurs only play a small, but important, role in the value of a currency. Currencies are simply a commodity, like any other, which has a price. Since the exchange rate is simply a price, it has the same basic determinants that any other price has: supply and demand. First we'll look at supply. Next page > Part 3: Exchange Rates  Demand > Page 1, 2, 3, 4, 5, 6, 7, 8. 