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BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN

AND UK 1

How to lose the exchange rate difference?usiness opportunities in

arbitrage between countries USA, Japan and UK

Nguyen Le Khanh Thy

Ho Huynh Khanh Hoang

Phan Thi Hoa Hieu

Le Tran Manh Linh

Nguyen Thi Diem Huong

IB17A01, FPT UNIVERSITY

IBF301: International Finance

Lecture: Doan Thuy Linh

March 18,2023
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 2

How to lose the exchange rate difference?

Arbitrage is when an asset is sold for less than its actual value or is purchased for

more than its true value. Investors will take advantage of the price gap to make a profit.

Currency arbitrage is an investment strategy that uses price differences between currencies on

different markets to make a profit. With those price differences, investors can buy the

currency in one call at a lower price and sell it in another at a higher price to profit from the

difference.

However, to conduct currency arbitrage successfully, investors must note several

factors as follows:

The price difference between markets needs to be large enough to make a profit after

deducting transaction fees and other costs.

Investors must have trading accounts on different exchanges to conduct currency

arbitrage. Therefore, they must manage these accounts efficiently to ensure they can make

transactions quickly and securely.

Market factors such as exchange rate fluctuations, competition between exchanges,

and differences in market opening times can also affect currency arbitrage results. Therefore,

investors need in-depth knowledge of the forex market and related factors.

Finally, investors need to manage risk when doing currency arbitrage. Factors such as

market-related, exchange rate, and financial risk can affect investment results.

Differences in Exchange Rates: When exchange rates differ in different markets,

investors can use arbitrage opportunities by buying and selling currencies for a profit.

Example: Suppose the USD/EUR exchange rate on exchange A is 1 USD = 0.83

EUR, and on exchange B, it is 1 USD = 0.85 EUR. An investor can buy 10,000 USD on

exchange A for 8,300 EUR and sell it immediately on exchange B for 8,500 EUR. After

deducting transaction fees and other costs, the investor's profit is 200 EUR (8,500 EUR -
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 3
8,300 EUR). If an investor uses leverage with a ratio of 1:10, he only needs to put in a

smaller initial amount to execute the trade. For example, if the influence is 1:10, he only

needs to deposit 830 EUR to buy 10,000 USD, then sell it on exchange B for 8,500 EUR to

make a profit of 170 EUR (8,500 EUR - 8,330 EUR). The profit margin is relatively high

because the USD/EUR price difference between the two exchanges is significant.

When price divergences occur, traders exploit their advantages to create a price

balance between markets. As some traders make such trades, the price difference gradually

diminishes until there are no more arbitrage opportunities.

Several factors played a role in arbitrage appearing in the UK, USA, and Japan:

Developed financial markets: The UK, the US, and Japan have developed and

expanded financial markets, with many types of assets being traded, such as stocks,

currencies, and commodities. As a result, the value differential across these markets also

increases.

Differences in time and location: Because different time zones and markets open at

different times, value differences can occur between these markets.

Interest Rate Differences: Countries have different interest rates, which affects the

exchange rates between currencies. For example, if interest rates are higher in the US than in

the UK and Japan, the dollar can appreciate against the GBP and JPY.

Legal Differences: Countries have different legal regulations, which can lead to value

differences in financial markets. For example, an American company may register its

securities on the US stock exchange and not be allowed to register on the UK or Japanese

exchanges.
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 4
To illustrate the emergence of arbitrage in the UK, USA, and Japan, we can

provide some statistics:.

Stock Value Differences: In 2021, the US stock index S&P 500 is up 27%, while the

UK stock index FTSE 100 is up 14%. Meanwhile, Japan's Nikkei 225 stock index rose 9%.

This divergence creates an arbitrage opportunity for traders who want to exploit the value

divergence in these markets. This means that if an investor buys stocks in the UK or Japanese

market and sells them in the US market, he can take advantage of the difference in value to

make a profit from buying and selling the shares. When the stock index rises, the value of the

stocks on the market also increases. However, uneven value growth across different stock

markets can make a difference in the value of the same inventory across other markets. So, if

stock A trades at a lower price on one exchange and a higher price on another, a trader can

buy and sell stock A at a lower price on that exchange. Immediately on another exchange

with a higher price to make a profit. This is called opportunity arbitrage.

Assume that the current exchange rates for the GBP/USD, USD/JPY, and GBP/JPY

currency pairs are as follows:

GBP/USD Rate: 1.4

USD/JPY Rate: 110

GBP/JPY Rate: 154

Traders will make the following transactions: A trader buys GBP in USD at

GBP/USD = 1.4. The trader will get 1,000,000 GBP worth of the equivalent of 1,400,000

USD.

Traders sell GBP to buy JPY at GBP/JPY = 154. Traders will get 154,000,000 JPY

from selling 1,000,000 GBP.

Finally, the trader sells JPY to buy back USD at USD/JPY = 110. Traders will receive

USD $1,400,000 from the sale of 154,000,000 JPY.


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 5
After making the above three trades, the trader will have 1,400,000 USD, which is

equivalent to about 1,000,000 GBP initially. As such, the trader has made a relatively small

profit (equal to what it would have cost them to convert currencies between countries), but it

can become substantial when done on a large scale. And when exchange rates change

quickly.

Interest rate difference: In 2021, US prime interest rates range from 0.00 - 0.25%,

UK interest rates range from 0.10 - 0.50% and Japanese interest rates range from -0.10% -

0.10%. This interest rate differential affects exchange rates and creates an arbitrage

opportunity for traders who want to exploit this difference. More specifically, suppose that

the interest rate in the US is 0.25%, the interest rate in the UK is 0.50%, and the interest rate

in Japan is -0.10%. In this case, a trader can perform arbitrage as follows:

Step 1: Borrow USD 1,000,000 from the US at an interest rate of 0.25%. Traders must

pay back USD 1,002,500 after one year (including interest).

Step 2: Convert USD 1,000,000 to the UK and convert to GBP at the USD/GBP rate

of 0.72. Traders will receive GBP 720,000.

Step 3: Lend GBP 720,000 in the UK at a 0.50% interest rate. After one year, the

trader will get back GBP 723,600 (including interest).

Step 4: Convert GBP 723,600 to Japan and convert to JPY at the GBP/JPY rate of

142. Traders will receive JPY 102,871,200.

Step 5: Lend JPY 102,871,200 in Japan with an interest rate of -0.10%. After one

year, the trader will get back JPY 102,758,080 (including interest)

.Step 6: Convert JPY 102,758,080 to the US and convert to USD at the JPY/USD

exchange rate of 0.009. The trader will receive USD 924,822.72

Thus, after completing the above chain of transactions, the trader will receive a total

of USD 924,822.72, surpassing the initial amount of USD 1,000,000. As a result, the trader
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 6
has made a profit by taking advantage of the difference in interest rates between countries.

However, it should be noted that financial markets are risky, and unexpected situations such

as exchange rate fluctuations or interest rate changes can cause a trader to incur significant

losses.
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 7

How to lose the exchange rate difference?

The exchange rate between the US dollar (USD) and the British pound (GBP), The

US dollar (USD), and the Japanese yen (JPY) are determined by the supply and demand for

each currency in the foreign exchange market. Exchange rates can fluctuate depending on

economic and political factors such as inflation rates, interest rates, trade balance, political

stability, and global economic events.

To eliminate or reduce the exchange rate difference between USD/JPY and

USD/GBP, they will rely on many factors, such as:

Direct intervention by central banks: it is possible to intervene in the foreign exchange

market to influence the exchange rate. They can buy or sell their currency in the market to

influence the supply and demand for that currency, which can affect the exchange rate.

Economic Policy: Economic policies like interest and trade can affect exchange rates.

For example, if the UK raises interest rates against the US, it could increase demand for GBP,

which could lead to an appreciation of the currency.

Balanced Trade: If the UK and the US or the UK and Japan can maintain a balanced

trading relationship, where exports and imports are roughly equal, that could help reduce the

exchange rate differential between the two countries. Coin.

Currency Valuation: 2 countries can also consider valuing their currencies against

each other. This would involve fixing the exchange rate between the two currencies, which

could help stabilize the exchange rate differential.

Below is a breakdown of the reduction or loss of the exchange rate difference between

the USD/JPY and USD/GBP currency pairs:

USD/JPY currency pair


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 8
The highest and lowest rates in history

Fixed Rate: (from 1944 to 1971) After World War II, the Yen lost value. Its exchange

rate has been fixed at 360 per dollar as part of the Bretton Woods system for stability. It

obligates each country to adopt a monetary policy to maintain exchange rates by tying its

currency to gold.

Free Floating Interest Rates: When the Bretton Woods system ended in 1971, the

United States stopped converting the US dollar to gold. JPY was undervalued and allowed to

float. Since then, the pair has reached a January 1973 high of 301.15¥/USD and an October

2011 low of 72¥/USD.

When the price of energy and many other essential goods is high globally, the weak

Yen increases the cost of Japanese imports. With a sharp increase in the amount of USD

purchased, this situation puts pressure on Japanese businesses' profits to decrease and causes

"wallet pain" for Japanese consumers. While the BoJ has not considered tightening, Prime

Minister Kishida has had to implement many measures to reduce the negative impact of the

yen's devaluation, including subsidizing gasoline prices.

In addition, to reduce the impact of rising prices due to the falling yen and economic

support recovery, Japan has just approved an economic stimulus package worth about 39

trillion yen (264 billion USD). The latest economic stimulus package came as the Bank of

Japan (BOJ) kept short-term interest rates unchanged at minus 0.1% - an interest rate

believed to increase downside pressure on the dong. Yen and pushed the world's third-largest

economy into an inflationary spiral.

GBP/USD currency pair

GBP/USD, commonly known as "The Cable," is a forex term used to describe the

British pound against the US dollar, one of the oldest trading currency pairs.
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 9
In recent years, the exchange rate has been affected by many factors, including the

Brexit vote in the UK, the COVID-19 pandemic, and economic recovery efforts in both

countries. Historically, the exchange rate between USD and GBP has fluctuated significantly

over the past decade. In 2011, the exchange rate was around 1.60 USD to 1 GBP. By 2016,

the exchange rate had dropped to approximately 1.2 USD to 1 GBP after the Brexit vote.

Since then, the exchange rate has remained relatively volatile, fluctuating due to economic

and political developments. As of March 2023, the exchange rate is around 1.36 USD to 1

GBP.

The pound's devaluation comes after UK Finance Minister Kwasi Kwarteng

announced historic tax cuts in the country. In addition, this currency was also under pressure

because the US Federal Reserve raised interest rates, causing the dollar to appreciate. The

pound remains this low against the dollar, making imports of dollar-denominated

commodities like oil and gas more expensive. Other imports from the US can also be

significantly more expensive, and British travelers in the US will find their holidays more

expensive.

The Bank of England is holding emergency talks with its international partners on

boosting liquidity if the situation worsens. The chain reaction began with the collapse of

Silicon Valley Bank (SVB), where the UK division was bailed out by HSBC bank.
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 10

How does it affect cash flow?

USD/JPY currency pair

According to economic theories, the exchange rate is determined in the long and short

run. The exchange rate in the long-term trend is determined according to the law of one price

and the theory of PPP (purchasing power parity). And when determining the exchange rate in

the long run, economists emphasize the consumption of goods by a country. If domestic

goods are consumed more, the domestic currency will increase in value (one domestic money

can be exchanged for more foreign currency). Four main factors must be considered when

determining the exchange rate in the long run: relative prices, tariffs, and quotas, preference

for domestic or foreign goods, and labor productivity across countries. The asset approach

determines the short-term exchange rate, i.e., considers the cross-country currency as an asset

class. The decision to hold the local or foreign currency determines the short-run rate.

The USD/JPY currency pair is one of the most important currency pairs in the forex

market, which will usually have a significant impact on the US and Japanese money flows:

Increased international trade (affecting exports and imports): As the dollar

appreciates, countries like Japan will have to pay more to buy products and services from the

US. This could lead to a decrease in US exports, causing US businesses to reduce sales and

revenue. However, it can also reduce the price of US imports.

Ex: When the Fed raised interest rates, but in Japan, they still kept the loose monetary

policy, causing the yen to lose a record value (currently 1 USD=133 yen). So Japanese goods

exported to the US will be cheaper and vice versa. Japan will be more expensive to import

goods from the US, so Japan will have to pay more to buy goods from the US.

Increased ability to attract investment from foreign investors: this is often seen as a

positive signal for foreign investors. The increase in the dollar's value signals that the US

economy is large and diversified, along with a developed and stable financial system. As a
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 11
result, foreign investors can seek investment opportunities in the US and simultaneously push

the value of US financial assets higher. Foreign investors can achieve greater profits from the

US. They are investing in stocks, bonds, and other assets in the United States. At the same

time, the value of other assets measured in JPY will decrease, making investing in the US

even more attractive. In addition, the USD/JPY rate affects the value of assets denominated in

USD or JPY, such as stocks and bonds.

There are several ways that we can profit from arbitrage, including:

Forex Trading: This is the most common way of investing in which you buy a USD or

JPY coin at a low price and sell it at a higher price to make a profit.

Buy stocks and bonds: Foreign investors can buy stocks and bonds of US/Japanese

companies to invest in the US/Japan stock market and then sell them when stocks/bonds

increase in price. To earn profits.

Direct investment: Foreign investors can directly invest in projects in the US/Japan,

such as investing in real estate, production, and business, or buying US/Japanese companies.

Investment through investment funds: Foreign investors can also invest through

investment funds, including stock investment funds, real estate investment funds, and mixed

investment funds.

Investing in Financial Derivatives: Derivatives like futures or options are also foreign

exchange investment options to profit from exchange rate differences.

Ex: Typically, in recent times, because of the impact of the acute pneumonia

pandemic, the price of oil has dropped to a record of 17 USD/barrel, which no one could have

predicted. Thus, if the price in the futures contract is determined to be 26 USD/barrel, the

"buying" units will lose 9 USD/barrel.


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 12
Now to offset the purchase price delay (Contango), many companies will combine the

spot and futures prices at the same time to hedge their risk, which means they can buy 50%

more barrels at 17 USD, that means it can reduce the loss from 9 USD to 4.5 USD, waiting to

sell when the price is higher to avoid risk or bring a significant profit. This action is to lock in

profits by buying natural oil and oil of sale forward contracts in the futures market.

Monetary policy: USD/JPY also affects the monetary policy of the US and Japan. If

USD/JPY rises, the US Federal Reserve can raise interest rates to control inflation and draw

capital from investors. This could lead to the attraction of cash flows into the US. Similarly,

the Bank of Japan may implement other monetary policies to stabilize the exchange rate and

enhance the stability of cash flows.

Monetary policy can strongly influence the USD/JPY exchange rate:

Easing monetary policy: If the central bank of the US or Japan decides to loosen

monetary policy, i.e., increase the money supply in the economy, this can decrease the

currency's value and reduce the USD/JPY exchange rate. At the same time, an increase in the

money supply can also increase money flow into riskier assets and lead to inflation.

Interest Rate Cut Policy: If the central bank of the US or Japan decides to cut interest

rates, this can reduce the attractiveness of the domestic currency, thereby reducing the

demand for that currency and the interest rate. USD/JPY exchange rate in the market. At the

same time, lowering interest rates could also incentivize investors to seek higher yields in

other markets. Investors can withdraw capital from the domestic market to invest in other

markets, contributing to the depreciation of the domestic currency. However, a policy of

cutting interest rates can increase the demand for domestic currency by reducing borrowing

costs and supporting economic growth, leading to an increase in the value of the domestic

currency.
BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 13
In the case of USD/JPY, if the US central bank cuts interest rates, the USD yields will

fall, making the USD less attractive against the JPY. This can reduce the value of the USD

against the JPY, leading to an increase in the value of the JPY and a decrease in the value of

the USD, i.e., a reduction in the value of the USD/JPY exchange rate.

Foreign exchange policy: Central banks can intervene in the foreign exchange market

by buying or selling US and Japanese currencies. This could affect the exchange rate between

the US and Japan, creating stability for the USD/JPY exchange rate. At the same time,

monetary stabilization policy can also make peace in cash flow and reduce risks for investors.

Ex: The US Dollar weakened in 2017 due to uncertain changes in President Trump's

economic policies. As a result, the yen has strengthened. At that time, 1 USD could only buy

112.69 yen at the end of 2017, and the yen continued to improve, with USD/JPY standing at

104.83 in March 2018.

After USD/JPY remained in the 104–114 yen range for two years, the yen gained

strength, with USD/JPY standing at 102.52 on March 9, 2020. However, the Japanese yen

weakened as USD/JPY reached 111.44 yen due to the US dollar's strengthening during the

pandemic. By April 2021, the yen had recovered, and USD/JPY had retreated to 107.94.

The decline of the Japanese economy when the yen not only depreciated against the

US dollar but also depreciated against the currencies of developing countries, even the

Russian ruble, which is a "victim" of the measures—solid economic sanctions from the US

and Europe.

The yen fell to a record low because of the difference in interest rates when the US

Federal Reserve (Fed) continuously raised interest rates over the past time, because of the

debt-to-GDP ratio of 200%, and due to the pressure of the US Federal Reserve—the aging

workforce. At the end of August 2022, Fed officials repeatedly said they would prioritize

raising interest rates to deal with inflation.


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 14
Therefore, the middle-interest rates in the two economies will be widened because the

Bank of Japan (BoJ) still shows a view to applying low-interest rates to implement the

loosening policy. Currency. The trend of selling yen and buying USD has increased, and by

September 1, the yen rate has dropped to a record level of 140 yen to 1 USD. (that depends

on the price trends in the US and the financial policy of the US and Japan)

GBP/USD currency pair

The GBP/USD pair is among the world's top 5 most traded currency pairs. Exchange

rate changes can significantly impact the cost of goods and services traded between two

countries. This rate affects many aspects of cash flow, as follows:

Trade: changes in exchange rates can affect the cost of raw materials and other inputs

used in production.

For example, if a UK manufacturing company imports raw materials from the US and

the pound weakens against the dollar, the cost of those raw materials will increase in pounds,

potentially causing higher production costs and higher finished product prices.

Revenue: For businesses that export goods or services to the US or have customers in

the US, a stronger pound can lead to lower sterling revenue. This is because sales earned in

US dollars will be worth less when converted back to pounds. Conversely, a weaker pound

can lead to higher sales in sterling terms.

For example, after the Brexit referendum in June 2016, the British pound weakened

significantly against the US dollar. This leads to increased UK exports to the US as UK goods

and services become more affordable for US customers. However, this increase was

somewhat offset by the lower revenue earned in sterling when these exports were converted

back into US dollars.


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 15
Similarly, in 2018 and 2019, when the pound was relatively strong against the US

dollar, British businesses exporting to the US had lower revenue in sterling. This is due to a

higher exchange rate, which means that US dollars earned by UK businesses are worth less

when converted back to pounds.

Debt: A stronger pound can lead to lower pound interest costs for businesses with US

dollar debt, as the debt is cheaper to pay off. Conversely, a weaker pound can lead to higher

pound interest costs.

Investments: For businesses that invest in the United States or have subsidiaries in the

United States, exchange rates can affect the value of those investments in pounds. A weaker

pound can decrease the value of those investments, while a stronger pound can lead to an

increase in value.

It shows that the GBP/USD exchange rate can significantly impact a business's cash

flow, and it is essential to monitor and manage this risk to ensure financial stability. Hedging

strategies, such as forwards or options, can help businesses mitigate the impact of exchange

rate fluctuations on their cash flows.


BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 16

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BUSINESS OPPORTUNITIES IN ARBITRAGE BETWEEN COUNTRIES USA, JAPAN
AND UK 17

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