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Chapter 7 - Arbitrage in FX Markets

Susmel FINA 4360 International Financial Management Dept. of Finance Univ. of Houston Chapter 7 - Arbitrage in FX Markets Last Lecture We went over effect of government on St FX rate regimes: Fixed, free float & mixed. CB sterilized (no effect on domestic Money Markets ) and non-sterilized interventions. This Lecture Effect of Arbitrage on St Arbitrage Definition: It involves no risk and no capital of your own. It is an activity that takes advantages of pricing mistakes in financial instruments in one or more Markets . That is, Arbitrage involves (1) Pricing mistake (2) No own capital (3) No Risk Note: The definition we used presents the ideal view of (riskless) Arbitrage .

Note: In developed markets (like the USA), all interest rates are quoted on annualized basis. We will use annualized interest rates (The textbook is completely mistaken when it quotes periodic rates!!) Now, consider the following (covered) strategy: (1) At time 0, we borrow from a foreign bank 1 unit of a foreign currency (FC) for T days.

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