Arbitraging in exchange may be briefly defined as the purchase of exchange on one country through another country. Thus, for example, when exchange on Paris is more plentiful in London than it is in New York, an exchange banker in New York needing a draft on Paris may be able to buy it cheaper in London than at home. The following example will illustrate a simple arbitraging transaction.2- A banker in New York sells a draft on Paris for 25,250 francs. The rate is 5.17 1/2 (5 francs 17 1/2 centimes to the dollar), so that he realizes on the sale $4,879.23. Cabling to London he finds that the rate there on Paris is 25.25 (£1 = francs 25.25). It will therefore take just £1,000 to buy the francs 25,250 he needs. Sterling exchange is selling at 4.84. He decides to buy a draft on London for £1,000, costing him $4,840, and sends it to London with instructions to his correspondent to buy with it a bill on Paris for francs 25,250 and to send it over to Paris to the credit of his account, By this triangular arrangement he has been able to sell to his customer a draft on Paris for $4,879.23 and to provide funds there to meet it at a cost of $4,840.
Speaking of exchange arbitration, Escher says: "Experts do not confirm their operations to the main centers, nor is three necessarily the largest number of points which figure in transactions of this sort. Elaborate cable codes and a constant use of the wires keep the up-to-date exchange manager in touch with the movement of rates in every part of Europe. If a chance exists to sell a draft on London and then to put the requisite balance there through an arbitration involving Paris, Brussels, and Amsterdam, the chances are that there will be some shrewd manager who will find it out and put through the transaction. Some of the larger banking houses employ men who do little but look for just such opportunities. When times are normal the margin of profit is small, but in disturbed markets the parities are not nearly so closely maintained and substantial profits are occasionally made. The business, however, is of the most difficult character, requiring not only great shrewdness and judgment but exceptional mechanical facilities.1
1 For full discussion of arbitraging, see Margraff: International Exchange, Ch. XXVI.
2 Escher, p. 98.