Does Arbitrage Destabilize Foreign Exchange Markets?
Point Yes. Large financial institutions have the technology to recognize when one participant in the foreign exchange market is trying to sell a currency for a higher price than another participant. They also recognize when the forward rate does not properly reflect the interest rate differential. They use arbitrage to capitalize on these situations, which results in large foreign exchange transactions. In some cases, their arbitrage involves taking large positions in a currency and then reversing their positions a few minutes later. This jumping in and out of currencies can cause abrupt price adjustments of currencies and may create more volatility in the foreign exchange market. Regulations should be created that would force financial institutions to maintain their currency positions for at least one month. This would result in a more stable foreign exchange market.
Counter-Point No. When financial institutions engage in arbitrage, they create pressure on the price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing discrepancies would become more pronounced. Consequently, firms and individuals who use the foreign exchange market would have to spend more time searching for the best exchange rate when trading a currency. The market would become fragmented, and prices could differ substantially among banks in a region, or among regions. If the discrepancies became large enough, firms and individuals might even attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a more integrated foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line with the market.
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