Explain and justify your answer. (Key terms: Law of one price, Locational Arbitr

Question

Explain and justify your answer. (Key terms: Law of one price, Locational Arbitrage, Price Discrimination and default Risk)

Why do we observe that European Countries post different interest rate while they are using the same currency, euro. Does this provide us to make an arbitrage profit? If it does, how does the market adjust to prevent it happening? Or, Can we simply not make any arbitrage profit from current situation? If not, explain why we see this differences in interest rate in Europe with same currency.

Explanation / Answer

European coutries pose different interest rates though using the same currency as the repayment capacity and the total population of the country are taken into account. Though the entire continent uses the same currency there is difference government governing each country. The different government account for different spenders of borrowed money and variety of productive tax payers. Productive tax payers account for variety of sources from which to get the money to repay.

Take for instance the Greek government spends a lot of money but there are no productive tax payers. But in the case of Germany its different as there is heavy population and the a lot of people to pay tax for. Greek goverment will be charging higher interest rate where as Germany government will be chargning lower interest rate.

In countries like India, the price of the commodity changes from state to state due to different tax systems in each state. So the percentage also differs to each state. So when there is interest rate fluctuation within one country, it is not a big deal to have different rates within many countries.

Yes, the condition of varied interest rates will definitely lead arbitrage profit since the amount of interest rates will directly affect the consumer spending and the price of the goods. Often in stock market the traders try to exploit arbitrage opportunities. Let us consider the example of a trader who buys a stock in a foreign exchange where the price of the stock has not been adjusted with the constantly fluctuating exchange rate. Hence the price of the stock on the foreign exchange is undervalued compared to the price on the local exchange. The trader thus makes profit from this difference.

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