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Arbitrage Trading: Comparative Advantage Revisited RESOURCE GUIDE The Net-Text in PaperBack Learning Objectives

The slope of the Trading Possibilities Frontier (TPF) provides a convenient way to visualize the OC price of the numeraire appearing on the horizontal axis of the TPF. Comparing the OC price between two trading paths shows that arbitrage gains arise from being able to purchase the numeraire at the lower rate (opportunity cost) and sell at the higher rate.

The direction of trade is crucial in currency arbitrage. The choice of buying or selling the currency in question depends upon the same principle as described in the concept of comparative advantage: the trading margin. Suppose that the pound sterling offers arbitrage profits. A trade must be found to buy sterling at the lower rate and to sell sterling at the higher rate.

Starting with dollars (assume this for the sake of my students who are mostly US citizens), if one wants to buy sterling, a move directly into the bilateral (reflexive) exchange market (BREM US-UK) allows a trade of sterling for dollars (a 1-trade path). The sale of pounds is more complicated (a 2-trade path). In this case, sell the pounds to obtain yen (trade yen for pounds at the prevailing rate), then sell the yen to get dollars (trade yen for dollars at the prevailing rate). If rates dictate, the trades are reversed.

The trading paths (1-trade vs. 2-trade) provide two different exchange rates, when the cross-market equilibrium condition does not hold. The direction selected depends on a comparison of the two rates using the trading margin. The 1-trade path involves trading dollars for sterling (or vice versa), whilst the 2-trade path requires trading dollar for yen and then trading the yen for the pounds (or vice versa).

Enter some exchange rates below and see a graph of the TPF for the dollar and the pound with arbitrage profit as demonstrated from the slopes of the TPF.

Suggest limits for the TPF (observed exchange rates):