Foreign Exchange: Arbitrage Opportunity (Critical Review)

By Jackie, Researcher

Topic: Education
Area of discussion: Finance

Chapter: Foreign exchange – Arbitrage opportunity

The objectives of this research are to find out how people actually earn money via foreign exchange, how they do that (the steps like what currencies they need to buy and sell), how to make a good use of arbitrage opportunity to earn unlimited profit, how to calculate arbitrage profit (sample questions, examples, and calculations are provided to ease understanding) and the limitation and assumption of arbitrage opportunity in foreign exchange (what conditions must be fulfilled in order for this ‘arbitrage opportunity’ to hold).

Introduction

Well, in finance, I always heard about “high risk, high return” concept, but this arbitrage concept is totally different. I was really amazed by its concept: No risk, unlimited return (profit is infinity). Ideally, ‘arbitrage’ involving a simultaneous transaction to be entered at the same time, that is, the purchase and sale of currencies at the same time in order to earn ‘arbitrage profit’ due to differences in currencies price quoted in different places (markets). It is a trade where profits are made by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies. The reason why no risk is involved is because transactions are entered simultaneously. There is no delay in time, as time resembles risk and uncertainly in finance. Unlimited profits are possible for an astute (alert and smart) trader by re-entering or repeating those transactions again and again, until the market become efficient or equilibrium.

Triangular arbitrage

Triangular arbitrage (also referred to as ‘cross currency arbitrage’ or ‘three-point arbitrage’) is the act of exploiting an arbitrage opportunity resulting from a pricing discrepancy among three different currencies in the foreign exchange market. A triangular arbitrage strategy involves three trades, exchanging the initial currency for a second, the second currency for a third, and the third currency for the initial. During the second trade, the arbitrageur locks in a zero-risk profit from the discrepancy that exists when the market cross exchange rate is not aligned with the implicit cross exchange rate.

Let’s look at this example:

Suppose we observe these banks posting these exchange rates:

—  Westpac quote - A$/€  A$1.2223/€

—  Barclays quote - A$/£  A$1.8410/£

—  Deutsche quote - €/£   €1.5100/£

[One round trip]

Westpac Bank uses A$1,000,000 to exchange to pound at Barclays Bank at A$1.8410/£. This will give Westpac Bank £543,183. This amount is then, exchanged to euro at €1.5100/£ at Deutsche Bank. This will give Westpac Bank €820,206. Finally, this amount is converted back to Australian dollar at A$1.2223/€ in Westpac Bank itself. This will give Westpac Back A$1,002,538.

Arbitrage profit for one round trip: A$2,538.

Condition for arbitrage opportunity:

It is assumed that Interest Rate Parity (IRP) did not hold. If IRP holds, then there will be no more arbitrage opportunity. Besides, transaction costs are normally ignored during calculation. In reality, transaction costs will lower down the arbitrage profit. In addition, it is assumed that no capital controls are involved. Governments sometimes restrict import and export of money through taxes and outright bans.

Interest Rate Parity (IRP)

The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. Ideally, Interest Rate Parity (IRP) is a non-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries.

An illustration when Interest Rate Parity (IRP) holds:

An illustration when Interest Rate Parity (IRP) failed to hold:

Additional readings, related links and references:

This link provides a simple definition and few good examples of arbitrage as well as certain underlying assumptions for arbitrage theory to hold. Good link to view at for new learners or beginners.

http://www.investopedia.com/ask/answers/04/041504.asp#axzz22rpEWn44

An explanation of what is arbitrage and how to use it in the forex market to generate quick, safe, profits.

http://www.youtube.com/watch?v=4dwFQNPnC8I

Step-by-step video tutorial and guides related to the ‘triangular arbitrage concept’ in currency markets.

http://www.youtube.com/watch?v=lKu2LAgEcpU&feature=related

Triangular arbitrage’s definition and calculation is available in this link. Extremely brief article, but I believe beginners can have a basic understanding about this concept by viewing this (at a glance).

http://www.investopedia.com/terms/t/triangulararbitrage.asp#axzz22spZeBHK

How to calculate currency cross rate and triangular arbitrage calculation to find arbitrage profit is shown in this link.

http://thismatter.com/money/forex/currency-cross-rates.htm

WARNING: Bad business analytics may be hazardous to your wealth !

You paid handsomely for the software, perhaps for consulting too and have had some bright sparks working on it for months: the results of your analytics project are in and the answer is ... useless without some understanding of how good the models are it's built on.  If the analyst cannot give you detail on how 'good" the model is for its purpose, all results should come with a wealth warning. 

BAD BUSINESS ANALYTICS MAY BE HAZARDOUS TO YOUR WEALTH.

Let's take a few real-life examples:

• A project to improve sales forecasting where the accuracy of the forecast was not measured either before or after the project.
• A project to maximize trailer loading (get more tonnage into freight trailers) with such a bad optimization model that it missed most of the opportunity.
• A system to improve On-Shelf-Availability (the % of product actually on shelf in grocery stores) built entirely from arbitrary rules with no measurement, at all, of...On Shelf Availability.  Check out my post Point of Sale Data – Supply Chain Analytics for more details on On Shelf Availability.
• Statistical inventory models to identify how much inventory you really need built entirely without  statistics. (Managing hundreds of $millions in inventory value)
• Countless excel models that calculate nothing of value.

I could go on..

In many cases the issue is that the people assigned to the task do not have the skills to wield the tools they need.  The trailer loading project listed above was developed without real understanding of how to build an optimization model.  The developer had found an extended version of Excel's "Solver"  tool on the internet (a good small to medium scale optimizer from Frontline Systems).  Unfortunately the Excel model  was bad enough that Solver could only find the optimal solution to the wrong question: the model ran without throwing an error; it was a small improvement on what went before; the results were implemented; and the opportunity to do it right (worth $millions) was lost for a few years.

In other cases, and I saw a new one just this last week, the software tools leave out the diagnostics you need to tell whether the model is good.  Predictive Analytics tools packaged for business use (like price/promotion modeling packages, sales forecasting tools) tend to do this.  I can only assume that this is to prevent confusing the user.  

Before you use any tool's output to make critical decisions, someone with good modeling skills (perhaps your Primary Analytical Practitioner)  needs to check that your models are sound.

As my father taught me: “If a job is worth doing, it's worth doing well.”  How can that not be true when your financial results depend on getting it right ?  

Absorption Vs Variable Costing (Critical Review)

By Jackie, Researcher

Topic: Education

Area of discussion: Cost & Management Accounting

Chapter: Income effects of alternative cost accumulation systems

The objectives of this research are to explain the differences between an absorption costing and a variable costing system, prepare profit statements based on variable costing and absorption costing system, explain the difference in profits between variable and absorption costing profit calculations, explain the arguments for and against variable and absorption costing, and a clear example was taken from college exam to be used in this discussion followed by step-by-step guide and answer.

Introduction

Basically, absorption costing treats all manufacturing costs as product costs, regardless whether they are variable or fixed. On the other hand, variable costing only treats those manufacturing costs that vary with output as product costs. Fixed manufacturing overhead is not treated as production cost under this method, but rather treated as period cost. Thus, the cost of a unit of product in inventory or cost of goods sold under the variable costing method does not contain any fixed manufacturing overhead cost and therefore, the product cost per unit computed using variable costing is always lower than the product cost per unit computed using absorption costing. Their similarity is both of them are in complete agreement regarding the treatment of non-manufacturing costs as period costs. Please note that, variable costing is also sometimes referred to as ‘direct costing’ or ‘marginal costing’.

The differences between absorption costing and variable costing

Let’s take a look at this sample question:

Some arguments in support of variable costing

Variable costing provides more useful information for decision making

Data required by CVP (cost-volume-profit) analysis can be taken directly from contribution format in income statement which is only available in variable costing. Those data are extremely useful in calculating expected sales level to break-even, or expected sales level to earn a specific profit, margin of safety and contribution per unit. Besides, those relevant costs data are also required for a variety of short-term decisions making. For examples, make or buy decision as well as product mix decision.

Variable costing avoids fixed overheads being capitalized in unsaleable stocks

When a company produced a large amount of stocks but did not sold all of them, the fixed production overheads incurred during that particular period will be included in stock valuation. The stocks will therefore be over-valued. Profit calculation for that particular period will be misleading, where by current period’s profits will be over-stated.

Some arguments in support of absorption costing

Fixed overheads are essential for production

Production of goods is not possible if fixed manufacturing overhead costs are not incurred. Thus, fixed manufacturing overhead costs should be allocated to units produced and included in inventory valuation.

Consistency with external reporting

External reporting requires all manufacturing costs (including fixed production overhead) to be included as part of product cost. That is why external reporting did not recognize variable costing method as they failed to include fixed manufacturing overhead costs inside their cost of production.

Addition readings, related links and references:

Variable Costing Vs Absorption Costing: Definition, explanation & unit cost computation.

http://www.accounting4management.com/variable_and_absorption_costing.htm

Income Comparison of Variable and Absorption Costing

http://www.accounting4management.com/income_comparison_of_variable_and_absorption_costing.htm

Advantages and Disadvantages of Absorption Costing System

http://www.accounting4management.com/advantages_and_disadvantages_of_absorption_costing.htm

Management Accounting: Variable Vs Absorption Costing

http://www.youtube.com/watch?v=MCnLP3mMmOc

Marginal Costing Vs Absorption Costing Homework Help, Tutoring

http://www.tutorsonnet.com/homework_help/cost_accounting/marginal_costing/marginal_costing_vs_absorption_costing_assignment_help_online_tutoring.htm

Stock Dividend Vs Stock Split (Critical Review)

By Jackie, Researcher

Topic: Education

Area of discussion: Finance

Chapter: Dividend policy

Subchapter: Alternatives to cash dividends – Stock dividend & Stock split

The objectives of this research are to find out what are the major differences and similarities between stock dividend and stock split, what are the effects on financial statements when a company issues a stock dividend or a stock split, how to enter those transaction into the appropriate accounts and the required adjustment that ought to be made to the financial statements. By the way, this topic is very popular as questions are often set out from this chapter in finance examination. Therefore, it is good to actually understand and gain some knowledge about the basic concept of stock dividend and stock split although we might not be playing shares in real-life.

Introduction

In term of definition, stock dividend (also known as ‘scrip dividend’) is a dividend payment made in the form of additional shares, rather than a cash payout. Ideally, company may decide to distribute stock to shareholders instead of cash dividend if the company’s cash availability is in unfavourable condition. These distributions are generally acknowledged in the form of fractions paid per existing share. An example would be a company issuing a 5% stock dividend for each single share held. On the other hand, stock split (also known as ‘scrip issue’, ’bonus issue’ and ‘free issue’) is a corporate action in which a company existing shares are divided into multiple shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because no real value has been added as a result of the split.

Let’s take a look at this example: 

Question taken from IICS past year examination, also special thanks to Mr.Lim for his kind teachings. 

Solution for (i):

When 10% stock is declared, then the number of shares outstanding will also be increased by 10%, that is from 10,000 shares to 10,000(1.1)=11,000 shares.

This indirectly indicates that the new share issued is equal to 1,000 shares.

The overall effects on the owner’s equity accounts are:

Common stock (£1 par value) will increase by £1,000 (£1 par value per share x 1,000 newly issued shares due to 10% stock dividend).

Capital surplus (also known as ‘share premium’) will be also increase by £24,000. Please note that share premium is equal to market price minus the par value. Thus, share premium per share is £25 per share - £1 per share = £24 per share. After that, this share premium per share needs to be multiplied by 1,000 shares in order to get £24,000 which is the total share premium due to 10% stock dividend.

Retained earnings will be decreased by £25,000. This is derived from the market price which is £25 per share, then multiply with 1,000 shares in order to get £25,000.

Alteration in owner's equity accounts after 10 percent stock dividend is declared

Solution for (ii):

(This is actually more or less, quite similar with question (i))

When 25% stock is declared, then the number of shares outstanding will also be increased by 25%, that is from 10,000 shares to 10,000(1.25)=12,500 shares.

This indirectly indicates that the new share issued is equal to 2,500 shares.

The overall effects on the owner’s equity accounts are:

Common stock (£1 par value) will increase by £2,500 (£1 par value per share x 2,500 newly issued shares due to 25% stock dividends).

Capital surplus (also known as ‘share premium’) will be also increase by £60,000. Please note that share premium is equal to market price minus the par value. Thus, share premium per share is £25 per share - £1 per share = £24 per share. After that, this share premium per share needs to be multiplied by 2,500 shares in order to get £60,000 which is the total share premium due to 25% stock dividend.

Retained earnings will be decreased by £62,500. This is derived from the market price which is £25 per share, and then multiplies with 2,500 shares in order to get £62,500.

Alteration in owner's equity accounts after 25 percent stock dividend is declared

Solution for (iii):

In this case, ‘three-for-one stock split’ means each existing share is divided into three. Therefore, the shares outstanding after the stock split will be 30,000 shares (10,000 shares x 3). When this happen the par value per share will also divided by the split ratio of three, i.e. £1 ÷ 3 = £0.3333 per share. Hence, these are the only effects of the split.

Please note that the equity accounts are unchanged except that the par value of the stock is changed by the ratio of new shares to old shares.

Alteration in owner's equity accounts after a 'three-for-one stock split' is declared

Solution for (iv):

For this question, it is a bit special because it is deal with ‘reverse stock split’, a condition where the shares are combined instead of splitting according to its ratio. For ‘one-to-five reverse stock split’, it simply means that for every five existing shares, they are combined into one share. Thus, 10,000 existing shares will become 2,000 shares after the reverse stock split (10,000 shares ÷ 5). The par value will change to £5 per share (£1 x 5).

Alteration in owner's equity accounts after a 'one-for-five reverse stock split' is declared

Extra sharing:
Additional question and answer of which I took from my college past year question, it is solely focus on essay part (the differences). Thus, very theoretical and need deep analytical skills.

This Q&A explains the differences between stock dividend and stock split, their effects on equity accounts
 and their respective accounting treatment with examples to aid explanation.

Additional readings, related links and references:

Part 5: Stock Splits and Stock Dividends

http://www.accountingcoach.com/online-accounting-course/17Xpg05.html

Chapter 14: Stock Splits and Stock Dividends

http://www.youtube.com/watch?v=gdJfysUxlWc

Stock Dividends and How They Are Different From Stock Splits

http://beginnersinvest.about.com/od/dividendsdrips1/ss/dividends-and-dividend-investing-101_4.htm

Chapter 18: Shareholders’ Equity (Stock Dividends and Splits)

http://connect.mcgraw-hill.com/sites/0077328787/student_view0/ebook/chapter18/chbody1/stock_dividends_and_splits.htm

The Effect Of Stock Splits & Stock Dividends On The Market Share Price

http://www.boscia.com/a260pages/Group07/dividends.htm