Effective exchange rate and arbitrage

1. Arbitrage
&
Effective Exchange Rate
DR RAJU INDUKOORI
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2. Arbitrage
• The price differentials of an underlying
currency with different foreign
exchange opens an opportunity to
profit.
• It is the process of buying the same
asset in different markets
simultaneously.
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3. Triangular Arbitrage
• Exchange rate discrepancy provides
an opportunity to buy currency pairs
simultaneously.
• It is a quick process as price
discrepancies will be identified by all
traders in forex market.
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4. Triangular Arbitrage
Example
Exchange rates
• INR / USD @ 80
• INR / AED @ 20
• AED / USD @ 4
If there is any change in one of the
exchange rate, rest of the exchange rates
will change automatically.
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5. Triangular Arbitrage
Example
• If INR / AED changes to 18, then
INR / USD also changes.
• Till the time it changes, there is
always an opportunity for
triangular arbitrage.
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6. Triangular Arbitrage
Example 6

7. NEER
 Nominal Effective Exchange Rate
 It is weighted average rate at which one
country's currency exchanges for a basket of
multiple foreign currencies.
 It is an indicator of a country's international
competitiveness in terms of the foreign
exchange market.
 Forex traders sometimes refer to the NEER as
the trade-weighted currency index.
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8. NEER Calculation
Where
E = Exchange Rate
t = Value of trade with first country
T = Total trade value of a country with all countries
N= Number of trading countries
T
t
E
T
t
E
T
t
E
T
t
E n
n
.......
NEER 1
1
1
1
1
1 


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9. REER
 Real Effective Exchange rate
 NEER is adjusted to the exchange inflation in the
respective countries.
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10. REER Calculation
Where
E = Exchange Rate
t = Value of trade with first country
T = Total trade value of a country with all countries
N= Number of trading countries
i = Inflation in the respective country
        T
t
i
E
T
t
i
E
T
t
i
E
T
t
i
E n
n
n







































1
.......
1
1
1
REER 3
3
3
2
2
2
1
1
1
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11. NEER and REER
 When the exchange rate is pegged or
fixed, there is no difference between
NEER and REER as exchange rate is
not determined by interest, inflation,
country risk kind of factors.
 Ex : AED / USD is fixed at 3.67
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