International financial markets Essay Example | Topics and Well Written Essays - 250 words

International financial markets - Essay Example Meanwhile, the mispriced item will have appreciated at a rate higher than that of the portfolio. The arbitrageur could thus short sell the portfolio at the present price and use the amount obtained to purchase the mispriced item. At the end of the period, the arbitrageur will sell the mispriced item, purchase back the portfolio, and then keep the difference as his profit. In this context, the arbitrageur utilizes the interest rates difference between two countries to make risk free profit. By the use of a forward contract to eliminate the threat of exchange rates, the arbitrageur makes profit from the fact that interest rates difference does not always hold(TEALL,2013). According to economists, factors such as fluctuating frequencies of time series data and diverse aspects of assets contribute to changes in interest rates. An example of an investor exploiting such an arbitrage opportunity due to pricing forwards; The investor borrows 800,000 of currency Y @ 2% per annum. This implies that that by the end of year, he will be required to pay 816,000. Currency X offers a higher one-year interest and therefore the investor converts the 800,000 currency Y to X at a spot rate of 1.00. The investors lock in the 4% rate on the deposit of the 800,000X and concurrently enters into a forward contract which, converts the full maturity amount of the deposit,(832,000X) into currency Y at the one-year forward at a rate of Y=1.0125X. After one year, the investor settles the forward contract at the agreed rate (1.0125). The investor remains with 821,728Y and after repaying his 816,000Y loan, he remains with 5728Y as his profit. There may be various arbitrage opportunities according to the binomial pricing model. For instance, a situation where stock price is (ST )at time (T)and there are only two time periods; (T= 0 and T = 1). Starting stock