Tuesday, July 13, 2010

Example of Currency Arbitrage

So at a party recently, I hijacked an otherwise pleasant conversation to explain currency arbitrage.  I created this blog to provide a venue for this sort of thing so I wouldn't do it at parties.  I failed, clearly.  The example I used was a good one, though, so I'll repeat and refine here.

Imagine a big multinational company like Toyota needs to make payroll on Friday.  They have to make a $500 million dollar payment to the US bank that pays their US employees on Thursday night.  The cash that they have to make this payment is in their Japanese bank, though, in Yen.  They arrange to use Yen to buy the $500 million that they need.

Now, suppose that before this trade, anyone engaging in relatively small amounts can trade 1 US Dollar for 90 Yen.  They can also trade 1 Euro for 109.8 Yen, and 1.22 US Dollar for 1 Euro.

When Toyota executes this large trade, though, it pushes the price of dollars up in relation to the price of Yen (it takes more Yen to buy a Dollar).  I touched on the reasoning behind this in the liquidity miniseries.  If an asset is suddenly desired more (less) than it was a moment ago, it's price will go up (down).  Dollars and Yen are simply assets being bought and sold.  So, instead of getting their $500 million Dollars for 45 billion Yen, the exchange rate changes, and Toyota has to pay 45.25 billion Yen.

Meanwhile, Euros are trading with Dollars and Yen at the same rates they were before.  This is where an arbitrageur makes some money.  A trader in Boston sees the Toyota trade go through the market, and she does the following:
  • Borrows $100,000 from her firm's trading account.
  • Sells 100,000 Dollars to Buy 9,050,000 Yen (moving the opposite direction as Toyota).
  • Sells 9,050,000 Yen to Buy 82,423 Euro.
  • Sells 82,423 Euro to Buy 100,556 Dollars.
  • Pays back the $100,000 to her firm's trading account.
  • Takes her husband out on a hot $556 date.
Arbitrageurs do this until the three currencies move back into equilibrium.

Friday, July 9, 2010

Broker versus Market Maker

I'm reading a book where the main character's father owns a book store and specializes in rare books.  He is also known around the world as someone who can find extremely rare books for those who want them.  I think this literary example might help some of you understand the difference between brokers and market makers.

He is acting as a broker when he helps find extremely rare books.  A buyer comes to him and says, "I want a first edition 'On the Origin of Species.'  Can you find one for me?"  He then works his network and keeps an eye out for that book.  When he finds one that someone is willing to sell, he assists in the negotiation of a price between the buyer and seller.  He takes a cut of the deal for his services as a broker.  A broker helps connect potential buyers and sellers so they can exchange goods.

His shop, with its stock of books (less rare of course), is a market maker.  He buys books that he thinks will sell at some point, puts them in his store at a higher price, and waits for buyers to purchase them.  The buyers and sellers never interact with each other, they only deal with the shop, the market maker.

Friday, July 2, 2010

We're the Red One, Redux

In We're the Red One, I mentioned that I couldn't find the original graph that was on the cover of Investor's Business Daily.  Then Nicole said she really preferred that graph, and I would find it if I loved her.

With this alignment, you can see that we eased into this recession more slowly than most previous recessions, but then it just kept getting worse.

When you hear people worrying about a double-dip recession, they are talking about something like what happened in 1948.  In that recession, the first bottom was at month 10, followed by a short recovery and a deeper bottom at month 13.

Thursday, July 1, 2010

You Could Use a Mint, Part III

So I am little annoyed with Mint at the moment, because it isn't syncing with all our accounts properly.  Notably, it won't connect with Sallie Mae for our student loan accounts.  That is understandable, I suppose, since Sallie Mae isn't that big of a lender, and doesn't service MILLIONS of Americans' student loans.  Lots of people are having the exact same problem I am, and Mint provides a pretty good forum to submit problems and find others with the same problem.  According to the listing for this bug, Mint is working on it.

On the plus side, I'm getting the hang of the budget functions.  It allows you a good amount of flexibility with different types of budgets.  Most of the budgets I set up are standard: so many $ per month for rent, cell phone, internet, utilities, etc.  You can also set up a budget that rolls over from month to month.  This is great for our eating-out budget, so we can save up for a big night out or even borrow for it ahead of time.  I also used that type of budget for things we buy regularly but not every month, like cat food.

I've discovered how Mint makes its money.  The service is free for me to use.  There is a tab on the site labeled "Ways to Save," that suggests financial services that I may be interested in.  For example, I can get a list of available CDs that have better interest rates than my savings account.  I can also shop for credit cards, banks, brokerages, and auto insurance.  I'm sure Mint gets a finder's fee for any service I buy through their site.