The five key theoretical relationships among spot exchange rates, Coursework

The five key theoretical relationships among spot exchange rates, forward exchange rates, inflation rates, interest rates that result from international arbitrage activities. Critical analysis - Coursework Example The effect of arbitrage on demand and supply is to realign prices so that no further risk-free profits are made. In international monetary and foreign exchange markets, arbitrage takes three forms namely; locational, triangular and covered interest arbitrage. Locational arbitrage occurs when the bid price of a bank for the same currency is higher than another banks selling price. On the other hand, triangular arbitrage occurs when the exchange rate quote is different from the calculated rate from spot rate quotes. Similarly, covered interest rate capitalizes on interest rate differential between two countries while covering the risk of exchange rate. It exploits the relationship between forward rate premiums and interest rate differentials. The arbitrage activities result in five theoretical economic relationships that explain the connections among prices, interest rates, spot exchange rates and forward exchange rates. The relationships are; purchasing power parity, Fischer effect, international Fischer effect, interest rate parity and forward rates as unbiased predictors of future spot rates (Werner and Stoner, 2010). It is a theory that determines the adjustments required in the currency exchange rates of two countries, to make them in equilibrium when their purchasing powers at that exchange rate are equivalent (Lyhagen, Osterholm and Calrsson, 2007). In other words, the expenditure on a particular commodity ought to be the same in both currencies once exchange rate takes it into account. For instance, suppose one US Dollar is selling at 120 Japanese yens. In the United States, say a baseball bat is selling for $50, while in Japan the same bat goes at JPY 500. Then it means the bat will cost only $10 if bought in Japan. It is advantageous to purchase the bat in Japan and consumers will show preference to the low cost. In the event of