Q.2 What is arbitrage? Explain with the help of suitable example a two-way and a three way arbitrage.
The balance of payments(or BOP) of a country is a record of international transactions between residents of one country and the rest of the world over a specified period, usually a year.Thus, India’s balance of payments accounts record transactions between Indian residents and therest of the world. International transactions include exchanges of goods, services or assets. Theterm “residents” means businesses, individuals and government agencies and includes citizenstemporarily living abroad but excludes local subsidiaries of foreign corporations.The balance of payments is a sources-and-uses-of-funds statement. Transactions such as exportsof goods and services that earn foreign exchange are recorded as credit, plus, or cash inflows (sources). Transactions such as imports of goods and services that expend foreign exchange arerecorded as debit, minus, or cash outflows (uses).The Balance of Payments for a country is the sum of the Current Account, the CapitalAccount and the change in Official Reserves
.The current account is that balance of payments account in which all short-term flows of payments are listed. It is the sum of net sales from trade in goods and services, net investmentincome (interest and dividend), and net unilateral transfers (private transfer payments andgovernment transfers) from abroad. Investment income for a country is the payment made to itsresidents who are holders of foreign financial assets (includes interest on bonds and loans,dividends and other claims on profits) and payments made to its citizens who are temporaryworkers abroad. Unilateral transfers are official government grants-in-aid to foreigngovernments, charitable giving (e.g., famine relief) and migrant workers’ transfers to families intheir home countries. Net investment income and net transfers are small relative to imports andexports. Therefore a current account surplus indicates positive net exports or a trade surplusand a current account deficit indicates negative net exports or a trade deficit.The capital(or financial) account is that balance of payments account in which all cross-border transactions involving financial assets are listed. All purchases or sales of assets, including directinvestment (FDI) securities (portfolio investment) and bank claims and liabilities are listed in thecapital account. When Indian citizens buy foreign securities or when foreigners buy Indiansecurities, they are listed here as outflows and inflows, respectively. When domestic residents purchase more financial assets in foreign economies than what foreigners purchase of domesticassets, there is a net capital outflow
. If foreigners purchase more Indian financial assets thandomestic residents spend on foreign financial assets, then there will be a net capital inflow
. A capital account surplus indicates net capital inflows or negative net foreign investment. A capital account deficit indicates net capital outflows or positive net foreign investment.
The official reserves account (ORA)records the total reserves held by the official monetaryauthorities (central banks) within the country. These reserves are normally composed of themajor currencies used in international trade and financial transactions. The reserves consist of “hard” currencies (such as US dollar, British Pound, Euro, Yen), official gold reserve and IMFSpecial Drawing Rights (SDR). The reserves are held by central banks to cushion againstinstability in international markets. The level of reserves changes because of the central bank’sintervention in the foreign exchange markets. Countries that try to control the price of their currency (set the exchange rate) have large net changes in their Official Reserve Accounts. Ingeneral, a net decrease in the Official Reserve Account indicates that a country is buying itscurrency in exchange for foreign exchange reserves, to try to keep the value of the domestic currency high with respect to foreign currencies. Countries with net increases in the OfficialReserve Account are usually attempting to keep the price of the domestic currency cheap relative to foreign currencies, by selling their currencies and buying the foreign exchange reserves. Whena central bank sells its reserves (foreign currencies) for the domestic currency in the foreignexchange market, it is a credit item in the balance of payment accounts as it makes availableforeign currencies. Similarly, when a central bank buys reserves (foreign currency), it is a debititem in the balance of payment accounts.The Balance of Payments identity states that:
Current Account + Capital Account = Changein Official Reserve Account.
If a country runs a current account deficit and it does not run downits official reserve to cover this deficit (there is no change in official reserve), then the currentaccount deficit must be balanced by a capital account surplus. Typically, in countries withfloating exchange rate system, the change in official reserves in a given year is small relative tothe Current Account and the Capital Account. Therefore, it can be approximated by zero. Thus,such a country can only consume more than it produces (or imports are greater than exports; acurrent account deficit) only if it has a capital account surplus (foreign residents are willing toinvest in the country). Even in a fixed exchange rate system, the size of the official reserveaccount is small compared to the transactions in the current and capital account. Thus theresidents of a country cannot have a current account deficit (imports exceeding exports) unlessthe foreigners are willing to invest in that country (capital account surplus).
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