Kenneth R. Szulczyk
the exchange rate differences. It does not matter which exchange rates we calculate the cross
rate from.
€ 1
$0.9625
€ 1. 6
1 £
1 £
$1.54
=
(4)
Step 1: Trader converts the U.S. dollars to British pounds at Citibank, yielding 64,935.06 £.
We calculate the result in Equation 5.
64 , 935. 06 £
$ 1. 54
1 £
$ 100 , (^000) =
(5)
Step 2: Trader converts the British pounds into euros at Credit Suisse, yielding 103,896.10
€. We compute the amount in Equation 6.
103 , 896. 10 €
1 £
€1.6
64 , 935. 06 £ =
(6)
Step 3: Finally, the trader converts the euros into U.S. dollars at Deutsche bank. Trader has
$100,779.22 and gains a $779.22 profit. We calculated the results in Equation 7. As the trader
converts money from one currency to another, he simultaneously creates demand and supplies
for currencies. Over time, the price differences between exchange rates disappear. In the modern
age, the international banks use computers to spot differences in exchange rates and quickly
execute transactions to profit from arbitrage.
$100,779.2 2
1 €
$0.97
103 , 896. 10 € =
(7)
Demand and Supply for Foreign Currencies
Demand function for a currency originates from international trade between Malaysia and
the United States. Price for Malaysian ringgits is the exchange rate of U.S. dollars per one
ringgit. We always show the currency price in the denominator of the currency exchange rate
because a price decrease reflects a currency depreciating while a price increase is an
appreciating currency. Demand for ringgits originates from U.S. consumers who want to import
goods and services from Malaysian companies. Thus, U.S. consumers need ringgits to pay for
the Malaysian goods. As U.S. consumers convert dollars into ringgits, the demand for ringgits
simultaneously creates a supply of U.S. dollars on the foreign exchange market.
We show the demand for ringgits in Figure 1. As we move from Point A to Point B, the
ringgit exchange rate falls. Thus, the ringgit depreciated because one ringgit buys fewer U.S.