94 CHAPTER 3. SPOT MARKETS FOR FOREIGN CURRENCY
and the issue is which of the two assets is cheaper to trade.^14 As a result, the
influence of shopping around can go on as long as the price difference exceeds
thedifferenceof the two transactions costs.^15- Second, arbitrage is a strong force because it does not require any capital
and can, therefore, generate enormous volumes. In contrast, shopping around
can be a price-equalizing mechanism only if there are investors who wish to
make that particular transaction. This exogenously triggered volume, if any, is
always finite and may be exhausted before it has actually equalized the prices.
In this section, we apply these arguments to spot rates quoted for the same
currencies by different market makers. In a perfect exchange market with zero
spreads, arbitrage implies that the rate quoted by bank X must equal the rate
quoted by bank Y: there can be only one price for a given currency—otherwise,
there is an arbitrage opportunity.
Example 3.10
If Citibank quotesdem/usd1.6500, while Morgan Chase quotesdem/usd1.6501,
both at zero spreads, then
- there is an arbitrage opportunity. You can buy cheapusdfrom Citibank and
immediately sell to Morgan Chase, nettingdem0.0001 perusd. You will, of
course, make as manyusdtransactions as you can. So will everybody else. The
effect of this massive trading is that either Citibank or Morgan Chase, or both,
will have to change their quotes so as to stop the rapid accumulation of long
or short positions. That is, situations with arbitrage profits are inconsistent
with equilibrium, and are eliminated very rapidly. - there is also a shopping-around pressure. All buyers ofusdwill buy from
Citibank, and all sellers will deal with Morgan Chase.
The only way to avoid such trading imbalances is if both banks quote the same
rate.^16
(^14) Accordingly, Deardorff (1979) refers to standard arbitrage astwo-way arbitrageand to shopping-
around asone-way arbitrage.
(^15) Denote byPUandkUthe price and transaction cost when dealing in the underpriced asset,
and denote byPOandkOthe counterparts for the overpriced asset. The advantage of buying the
cheap asset rather than the expensive one remains positive as long asPU+kU< PO+kO; that is,
as along asPO−PU> kU−kO. In contrast, the advantage of buying the cheap asset and selling
the expensive one remains positive as long asPO+kO−(PU−kU<)>0; that is, as along as
PO−PU> kU+kO: you pay both costs instead of replacing one by another.
(^16) This is often put as “by arbitrage, the quotes must be the same,” or “arbitrage means that the
quotes must be the same.” Phrases like this actually mean that to rule out arbitrage opportunities,
the quotes must be the same.