Currency Speculation and Arbitrage

CURRENCY SPECULATORS AND arbitrageurs made huge profits during the 1997 East Asian Crisis. They took advantage of the flaws inherent in the global fiat monetary system. These speculators, that include international financial institutions and fund managers, are very knowledgeable about financial markets, economic cycles, etc. They use this knowledge to “attack” currencies, etc. to reap huge profits. The huge economic bubble that hovered over the East Asian countries, created by the fiat money credit bubble[1], lured these speculators to attack the currencies of these countries by shorting them. Their action popped the bubble that brought about the 1997 East Asian crisis. Collective action of speculators would amount to an attack on the currency. While the central bank may counter such attacks to keep exchange rates within reasonable levels, a continuous attack can be difficult for the central bank to match. While speculators can take on huge leveraged positions, the central bank would need large amounts of foreign reserves to counter this. Inability to match the speculators would cause the exchange rate to plunge as happened to the Asian currencies.

Currency Speculation and Arbitrage

The ringgit depreciated from an exchange rate of about RM2.47 to the dollar before the crisis to a rate of RM4.80 at some point in time during the crisis.

While one may argue that it is ethically not right for speculators to attack a currency, it is the current global monetary system that allowed them to do so. When an exchange rate moves due to speculative attacks or otherwise, it breaks the equilibrium among currencies. This makes it possible for further profiteering called arbitrage profits. Arbitrage is like finding money on the ground. An example of currency speculation and arbitrage is given below.

Currency Speculation and Arbitrage: An Example

Consider the ringgit when it was attacked in August 1997. The shorting of the currency by speculators pushed the ringgit downward. Let us assume an initial exchange rate between three currencies, say, the ringgit, dollar and Singapore dollar as below:

The ringgit exchange rate is RM2.40 and RM1.50 to one dollar and Singapore dollar respectively. The Singapore dollar rate is S$1.60 to the dollar.

Such exchange rates are in equilibrium since no one can make profit by just trading between the three currencies. If one were to start with a dollar, exchange it into Singapore dollar, then change the Singapore dollar into ringgit and then back into US dollar, one would end up with a dollar again[2].

Now assume that the shorting of the ringgit by the speculators pushes the exchange rate to RM3.80 per US dollar as shown below:

By attacking the currency as such, the traders make two types of profits:

(i) speculative and

(ii) arbitrage profits.

Speculative Profit: Speculative profit comes from the speculating that a currency would appreciate or depreciate (either due to economic factors or the speculative attacks themselves or even both). If the speculation is correct, then the traders would make profits, however, if their speculation turns out to be wrong, they would then make losses. In our example, profit is made as follows. First, the trader sells short RM2.4 million ringgit at the initial exchange rate of 2.40 per dollar. This equals US$1 million and would be credited to his account. Assume now that the attack caused the ringgit to depreciate to RM3.80 per dollar. Now at this new exchange rate the RM2.4 million is worth only US$0.63 million[3].

Therefore, the trader closes his position by buying back the RM2.4 million at this new rate and makes a handsome profit of US$0.37 million (i.e. US$370,000!). Even though the trader makes a hefty speculative profit of about US$370,000, the profit does not end there. There is another profit to be made — the arbitrage profit.

Arbitrage Profit: Arbitrage profit is made from the mispricing or disequilibrium among the exchange rates. In our example, this disequilibrium happened when the ringgit exchange rate moved. Arbitrage profits are realized at a point in time unlike speculative profits that require a span of time. In the above example the arbitrage profit is made as below:

Step 1: Borrow US$1 million[4] and exchange it into RM3.8 million (at the new prevailing exchange rate of RM3.80 per US dollar).

Step 2: Exchange the RM3.8 million into S$2.533 million (at the exchange rate of RM1.50 per Singapore dollar)

Step 3: Exchange the S$2.533 million into US$1.5833 million (at the exchange rate of S$1.60 per US dollar)

Step 4: Return back the loan of US$1 million, and keep the remaining  US$583,333 as arbitrage profit[5].

Hence the total speculative and arbitrage profits equal 370,000 + 583,333 = US$953,333. Note that for a transaction of US$1 million each in the speculative and arbitrage activities, the profit is almost a whopping US$1 million too! Currency traders, however, do not just trade in millions but rather in billions! Hence imagine the amount of profits they would be making!!

As arbitrageurs make profit through their actions, the exchange rates between currencies would move until the arbitrage opportunity is eliminated. In our example since a profit is made by first exchanging US$ into ringgit, there would be a tendency for the ringgit to appreciate over the US dollar (or to “fight back” the attack). Similarly, the action of exchanging ringgit into Singapore dollar would make the Singapore dollar appreciate over the ringgit. The last transaction of changing the Singapore dollar back into the US dollar would cause the US dollar to appreciate over the Singapore dollar. Therefore, even though the speculators attacked only the ringgit, the Singapore dollar would appreciate over the ringgit and the US dollar would appreciate over the Singapore dollar until the arbitrage opportunity is eliminated. A final exchange rate as below would have eliminated such an arbitrage opportunity and would now form the new equilibrium exchange rate between the three currencies:

An arbitrage profit, as shown above, can be made with any three currencies and need not be using only the ringgit, the US dollar and the Singapore dollar. Therefore, movements of all cross-currency rates could be expected. Nonetheless, only three currencies are needed for making an arbitrage profit. It takes only three currencies to break equilibrium and make arbitrage possible. For this reason such an arbitrage is also called a triangular arbitrage[6].

Speculative and arbitrage profits using national currencies are made possible by the mere existence of numerous fiat currencies that are volatile in nature. The global fiat monetary system provides a fertile ground for speculation, manipulation and arbitrage in the foreign exchange market[7].


[1] But erroneously termed the ‘Asian Miracle’.

[2] In this example we have ignored transaction costs. In practice, the buying and the  selling rates for currencies would differ; the difference being the profit to the bank or money changer. Ignoring transaction costs, however, does not affect the illustration of this example.

[3] In practice the speculators and arbitrageurs would not wait till the exchange rate moves this much in order to profit. Profits are realized when the exchange rate moves enough to cover transaction costs.

[4] Since arbitrage is done at a point in time, one may borrow this US$1 million probably for just a few minutes within which the entire transaction could be completed, particularly if transactions are done on-line using computers.

[5] Note that, in the example, the arbitrage transactions must be done clockwise starting from any of the currencies. This example starts from US$. If we had started using RM1million, the profit would have been RM583,333 instead. Transactions done anticlockwise would result in losses. Therefore, upfront one needs to determine the direction for making arbitrage profits — clockwise or anti-clockwise.

[6] If profit is made using four or more currencies, then all transactions except three are either redundant or they reduce the profit made. Mathematically, if all the cross exchange rates were placed in a matrix, equilibrium would imply the determinant of the matrix to equal zero. If the determinant does not equal zero, then it implies arbitrage opportunity exists somewhere between the currencies.

[7] Back in the 1970s, the daily global volume of foreign exchange transactions was around $10-$20 billion. By 2000, the average transaction was around $2 trillion! See Bernard Lietaer, The Future of Money, Century, 2001, p.312.

Comments

  1. hi Ahamed. i am writing from kenya where right now our kenyan shilling has really weakened against the dollar, pound and euro. our central bank says that there was speculation and arbitrage n your article has shed light on these. i always want to keep updated on financial markets/investments since that is the field i want to venture into by studying actuarial science. is this the right way to go about it and what would recommend for a person who wants to become a finance guru. thankyou.

  2. It’s really a great and helpful piece of information. I’m satisfied that you shared this useful information with us.
    Please keep us up to date like this. Thanks for sharing.

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  2. […] is confused about foreign exchange rates and speculation (which I think includes almost everyone), here is a clear explanation provided by Prof. Dr. Ahamed Kameel Mydin Meera of the International Islamic University of Malaysia. […]

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