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Based on volume, the foreign exchange market is the biggest in the entire globe. Foreign currency markets, also referred to as FX markets, deal with currency trading as their name suggests. A global marketplace where interested parties can buy, sell, and exchange currencies at set values is known as the forex market. Large international banks are the main players on the foreign exchange market. Along with individual brokers, hedge funds, investment management companies, and forex investors are other participants in the FX markets. This article will explain how arbitrage issues in global finance are faced by the forwards, futures, and option currency markets.
Before we venture into the description of the markets, it is important to understand the derivative concept. Given the nature of trading currencies, derivatives are used to determine the value of other variables such as equity, asset, and commodities. According to Carbaugh (2009), a derivative is an instrument whose value is obtained from the pricing of other basic variables. The basic variables are referred to as "Bases" and include reference rate, index, and underlying asset in a contractual setting. The main currency derivatives are futures, forwards, and options as discussed below.
The forwards market is an informal financial marketplace that deals with contracts for future delivery. A forward market derives its name from the dealings of forwards contracts. For a contract to hold water, there must be an agreement. A forward contract is an agreement to sell or buy a physical or financial asset in the future at an agreed date for a predetermined price. It is also important to note that a currency forward contract is a private transaction orchestrated over the counter between two parties under agreed terms and conditions.
The futures exchange market features a centralized financial exchange platform where people trade standardized future contracts. The future contract is a subnet of the forward contract. This is to say that a currency future contract is effectively a forward contract that is traded on a public exchange such as the New York Board of Trade (Nybot) and International Monetary Market (IMM) among others. The futures are unique in that they feature standardized structures such as minimum price increments, settlement and delivery dates as well as units of trade. In the case of private futures investors, the counterparties remain anonymous to each other as the transactions are facilitated by the margin brokers.
Similar to other markets, a CO market gives the holder of the option the right, but not the obligation, to sell or buy their currency futures at a fixed price at a future date. In Cos, the investors are expected to pay a premium for choosing to exercise their option. The premium amount is determined by the volatility of the current exchange rate. Normally, the CO is exercised by importers, travelers, and investors as the hedge out their portfolios against the changes in the exchange rate. As such, the currency options provide protection against fluctuations in the exchange rate on their investment portfolios.
In the financial markets, arbitrage is the process of identifying differences in the value of equities, commodities, and currencies in the FX markets and simultaneously buying or selling in a bid to earn revenue. In the past, arbitrage opportunity was realized due to information asymmetry in the currency markets. However, the modern day is marked with technology by use of computers which are able to detect pure arbitrage in the markets which are risk-free. As such, for individual brokers and day-to-day traders, their opportunity of breaking even from currency trade has been minimized. However, there is a loophole left by the technology involving risk arbitrage (Twomey, 2012). Risk arbitrage involves speculation about future events in the fluctuation of exchange rates.
Generally, all markets highlighted in this paper rely on the dynamic nature of the prices. In other words, the forex exchange market is characterized by changes in the value of securities. The change can also be interpreted as the risk when the future is uncertain. For a party to earn a profit, there must be an increase in value from buying or even selling. The decisions on whether and when to buy or sell lies on real-time communication and research. In international finance, the challenge of information asymmetry and inadequate real-time communication promotes the existence of such markets. However, the markets are also beneficial since they bring about an equilibrium in the market. International finance always has its interest on monetary relations between countries. However, since different economies use diverse currencies, the forex currency markets determine the value of each currency and how they trade with their counterparts. According to Garner (2012), such a phenomenon complements market imperfections by providing an expanded opportunity set with the aim of curbing the arbitrage problem.
Carbaugh, R. J. (2009). International economics. Mason, Ohio: South-Western Cengage Learning.
Garner, C. (2012). Currency trading in the forex and futures markets. Upper Saddle River, N.J: FT Press.
Twomey, B. (2012). Inside the currency market: Mechanics, valuation, and strategies. Hoboken, N.J: Bloomberg Press.
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