​Two-point Arbitrage

Let us consider an example to understand the concept of two-point arbitrage.

Assume Bank X quotes the rates USD/INR: 45.50/45.65. At the same time, the quote from Bank
Y is: USD/INR: 45.25/45.40.

This scenario provides an arbitrage opportunity. A market participant can buy U.S. dollars at
INR 45.40 from Bank Y and sell them to Bank X at INR 45.50. These two transactions provide a
profit of INR 0.10 per U.S. dollar involved in the transactions. This profit is known as ​arbitrage
profit​,​ and it is made without any risk or commitment of capital.

Triangular Arbitrage

If three currencies are involved in an arbitrage operation, it is called a three-point arbitrage or a

triangular arbitrage. In a triangular arbitrage, one currency is traded for another currency, which
is traded for a third currency, which, in turn, is traded for the first currency. For example, assume
a firm wants to convert INR to GBP. It can do so directly. The number of British pounds to be
received per unit of INR is given as INR/GBP. The firm can also get pounds indirectly from INR
to USD and then from USD to GBP. This is diagrammatically represented in ​Figure

For arbitrage profit in triangular trading to be zero, the product of the exchange rates should be
equal to 1​. That is, (USD/INR) × (GBP/USD) × (INR/GBP) = 1.

But the product of the exchange rates is less than or more than one,, there is an arbitrage
opportunity.to make an riskless arbitrage profit

The arbitrageurs will bring the exchange rates back into equilibrium through the buying and
selling of currencies. Buying a currency raises the exchange rate of that currency and selling a
currency lowers the exchange rate of that currency. Therefore, arbitrage activities continue to
effect changes in exchange rates until equilibrium is restored.

in these days of highly advanced communication networks, arbitrage opportunities very rarely
exist. If at all they exist, they will disappear very soon as every market participant is vigilant and
would revise the rates as frequently as necessary. Nevertheless, the role of arbitrageurs is very
important, particularly in ensuring equilibrium or parity in exchange rates.

EXAMPLE:

Nostro, Vostro, and Loro Accounts

Nostro, vostro, and loro are Italian terms meaning “our,” “your,” and “their,” respectively.

In interbank transactions, foreign exchange is transferred from one account to another account
and from one centre to another. In order to facilitate easy and swift transfer of funds in different
currencies, banks that are ​authorized dealers​ (AD) in foreign exchange maintain current
accounts in different foreign currencies with overseas branches/correspondent banks located at
different centres. Such a foreign currency account maintained by a bank at a foreign centre is
known as a ​nostro account,​ ​ or “our account with you.”​ All sales of a particular foreign currency
would result in debits to the nostro accounts, and all purchases of that particular currency would
result in credits to the nostro accounts.

Foreign branches/correspondent banks also maintain accounts in their own currencies with this
particular bank (the bank which maintains the nostro account). Such an account is known as a
vostro account​, or “your account with us.”

There is a third type of account, known as a​ ​loro account​, wherein a bank remits funds in foreign
currency to another bank for credit to an account of a third bank.

Foreign Exchange Management Act (FEMA) & Foreign Exchange Regulation Act (FERA)
Why was FERA replaced?- ​FERA did not comply with the post-liberalisation policies of the
Government.

What is the main change brought in FEMA compared to FERA?- ​It made all the criminal
offences as civil offences.

What is FERA?
Foreign Exchange Regulation Act (also known as FERA), was introduced in the year​ 1973.​ The
act came into force, to regulate inflow and outflow of foreign currency, foreign payments,
securities and purchase of fixed assets by the foreigners.
It aimed at conserving foreign currency and its optimum utilisation for the development of the
economy.
What is FEMA?
It is a set of regulations which empowers Reserve Bank of India to pass regulations and enables
Government of India to pass rules relating to foreign exchange in tune with foreign trade policy
of India.
In the budget of 1997-98, the government had proposed to replace FERA-1973 by FEMA
(Foreign Exchange Management Act). ​It came into force on June 1, 2000.
Under the FEMA, provisions related to foreign exchange have been modified and liberalised so
as to simplify foreign trade and payments.
The important goal of FEMA is to amend and integrate all laws related to foreign currency in
India. In addition to this, FEMA aims to promote foreign payments, export of the country and
promote foreign capital and investment in the country to promote holistic development of India.
FEMA also encourages the maintenance and improvement of the foreign exchange market in
India.
Main Features of Foreign Exchange Management Act, 1999
1. It gives ​powers to the Central Government to regulate the flow of payments​ to and
from a person situated outside the country.
2. All financial transactions concerning foreign securities or exchange cannot be carried out
without the approval of FEMA. All ​transactions must be carried out through
“Authorised Persons.”
3. In the general interest of the public, the Government of India can restrict an authorised
individual from carrying out foreign exchange deals within the current account.
4. Empowers RBI to place restrictions on transactions from capital Account ​even if it
is carried out via an authorized individual.
5. As per this act, Indians residing in India, have the permission to conduct a foreign
exchange, foreign security transactions or the right to hold or own immovable property in
a foreign country in case security, property or currency was acquired, or owned when the
individual was based outside of the country, or when they inherit the property from
individual staying outside the country.
 ​FOREIGN EXCHANGE DEALERS' ASSOCIATION OF INDIA (FEDAI)

Foreign Exchange Dealer's Association of India (FEDAI) was set up in 1958 as an Association
of banks dealing in foreign exchange in India (typically called Authorised Dealers - ADs- ​The
banks which are officially authorized by RBI to deal in foreign exchange transactions are called
‘Authorised Dealers​) as a ​self regulatory ​body and is incorporated under Section 25 of The
Companies Act, 1956

some of the functions are as follows:

• ​Guidelines and Rules for Forex Business.

• ​Training of Bank Personnel in the areas of Foreign Exchange Business.
• ​Accreditation of Forex Brokers
• ​Advising/Assisting member banks in settling issues/matters in their dealings.
• ​Represent member banks on Government/Reserve Bank of India/Other Bodies.
• ​Announcement of daily and periodical rates to member banks.
International Financial Management

5.4 Comparison of Purchasing Power Parity, International Fisher Effect and Interest
Rate Parity Theories

5.5 Summary

5.6 Keywords

5.7 Review Questions

5.8 Further Readings

Objectives
ED

After studying this unit, you will be able to:

IT
ED
OT

Introduction

The phenomenon of exchange rates movement is an important issue in international finance

N

and managers of multinational firms, international investors, importers and exporters and
government officials attach enormous importance to it. In fact, they have to deal with the issue
of exchange rates every day. Yet, the determination of exchange rates remains something of a
mystery. Forecasters with the most impressive records frequently go wrong in their calculations
by substantial margins. However, many times poor forecasting is due to unforeseeable events.
For example, at the beginning of 1984, all forecasters uniformly predicted that the dollar would
decline against other major currencies. But the dollar proceeded to rise throughout the year
although in other respects the general performance of the world economy did not radically
depart from forecasts. This clearly shows that the theoretical models or other models used by

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