The Cross-Rate and the Tripartite Arbitrage
Each currency has as many exchange rates, as there are currencies. Currency exchange rates, having different numerical expression, are interrelated and constitute an aggregate of prices, interconnected by the tripartite arbitration. The tripartite arbitration is an exchange operation of two currencies through a third one in order to get profits by using the difference between the exchange rate and the cross rate.
Cross rate is called the exchange rate of two currencies (A and B) through a third currency (C). Determination of the cross-rate is done by the conversion of the currency "A" into the currency "C" first, and then - the currency "C" into the currency "B":
(a / O x (c / b) = a / b (5.4)
Arbitrageurs' actions create additional supply of one currency and the additional demand for another currencies. Competition between arbitrageurs causes that profit from arbitrage is so small that practically exchange rate and cross-rates are equal. However, the tripartite arbitration creates a mechanism that equalizes the demand and supply for currency in all currency markets. Consequently, the export always increases the value of a country's currency when it is measured in the currencies of other countries, and imports reduces the value of the currency no matter what country the export goes to and what country the import goes from.
Cross-rates are a secondary measure and is calculated through the ratio of major currencies to the dollar.
The next cross-rates are calculated most commonly: the pound sterling to the Japanese yen, the euro to the Japanese yen, the euro to the Swiss franc.
Types of Exchange Rates According to the Degree of Flexibility
There are such major exchange rate regimes in the international practice: fixed, floating (flexible) and pegged.
The fixed exchange rate regime is a system in which the exchange rate is fixed, and its changes under the influence of fluctuations in supply and demand eliminated by government stabilization measures. The classic form of fixed rate is the currency system of the "gold standard", when each country sets the gold content of its currency. Exchange rates in this case are fixed ratio of the gold content of currencies.
The fixed exchange rate can be fixed in different ways:
1. Fixation of the national currency to the exchange rate of the most significant currencies of international payments.
2. Using the currencies of other countries as a legal means of payment.
3. Fixation of the national currency to the currencies of other countries, which are the main trading partners.
4. Fixation of the national currency to the collective currency units, such as SDR.
The advantages of fixed exchange rates should include the fact that when the rate is stable, it: provides companies with a sound basis for planning and price formation; limits domestic monetary policy; has positive impact on the underdeveloped financial markets and financial instruments.
Disadvantages of fixed exchange rates are as follows:
- if they are not trustable, they can succumb to speculative activities, which can further cause the rejection of a fixed exchange rates;
- there is no reliable way to determine whether the chosen rate optimal and stable;
- the fixed rate provides the readiness of the central bank to carry out the currency intervention in order to support it .
The whole system of fixed exchange rate can only solve short-term problems associated primarily with high inflation and instability of the national currency. In the long run such a currency regime unacceptable, because the differences in the growth rate of production capacity is not being adequately reflected in the changes in relative prices and the allocation of resources among different groups of goods and services, resulting in accumulated imbalances in the structure of the national economy.
In countries with market economy and a high level of income, as a rule, there are market (floating) exchange rates.
Flexible or freely floating exchange rates mea n the regime, whereby exchange rates are determined by the untrammeled play of supply and demand. The currencies market is balanced by means of the price, i.e. rate mechanism.
Advantage of market exchange rates is that they, because of free fluctuations in the demand for the currency and its supply, are automatically adjusted in such a way that eventually unbalanced payments are eliminated; the black marketers have no possibility to make a profit at the expense of the central bank; the central bank does not need to carry out currency interventions.
The disadvantages are the fact that markets do not always work with a perfect effectiveness, and therefore there is a risk that the exchange rate will be on the unreasonable by economic forecasts level for a long time; the uncertainty about the future exchange rate may create problems for the company in the field of planning and price forming; the freedom of an independent domestic monetary policy may be compromised (for example, if the government does not have the means to resist the currency depreciation, it can pursue the inflation, fiscal and monetary policies).
Compromise exchange rates mean the regime, at which the elements of fixation and free floating of exchange rates are combined, and regulation of the foreign exchange market only partially implemented by the movements of the exchange rates by themselves. It can be:
- the support for the fixed rate by making minor changes in the economy, and in case of their insufficiency through currency devaluation and the determination of a new official fixed exchange rate;
- the regulated float of currencies, when the authorities change the exchange rate gradually until it reaches the new parity. It can be: a) "sliding peg" -daily devaluation on predesigned and declared value, and b) "crawling peg" - the drop in the exchange rate with a pre-announced intervals by a certain value, and c) a "dirty float" - the daily devaluation on not previously declared value. However, the government is taking steps to adapt to the new economic situation.
If the supply does not meet the demand for a given official exchange rate, the currency is traded illegally at the exchange rate of the black market. Offshore exchange rate refers to the unofficial price of regulated currencies, whose transactions are carried out in the offshore areas.