A COMMODITY cannot command two different prices in two different markets," said Professor Chatshow, kick-starting a session in financial economics. "That's no great shakes," screamed a backbencher, sporting a t-shirt carrying the legend, "me Tarzan, you Jane". That kind of irreverence, both in the learning mode and in the dress code, could be seen only at this B-school. Yet that hadn't stopped it from cracking into the elite league of India's top ten.
"Explain," snapped the professor. Flowers responded. "Let's suppose a notebook costs Rs 20 at a stationery shop and Rs 25 at the nearby stationery shop. What would I do? Well, I would buy 1,000 notebooks from the first and sell 1,000 notebooks to the second and pocket Rs 5,000 in a single day". A lone voice asked, "but Flowers, would the second shop also buy at Rs 20?" Flowers responded, "let us assume so." The girl in the middle row (GITMR) did some rapid arithmetic. "Sir, at that rate, Flowers would earn Rs 1,50,000 a month or Rs 18 lakh per annum. And he would stop coming to class." Someone hissed, "that is the kind of money which even the professor doesn't make". The class roared.
"Wisecracks apart, that was a good example of what is called arbitrage," said Chatshow. And then asked, "but will Flowers really make Rs 18 lakh in one year flat?" Boka got into the act. "Nope. When Flowers drops into the shop on the third day to buy the third thousand, the shopkeeper might up the cost by Rs 1 to touch Rs 21 to see whether Flowers would still buy. Of course Flowers would, since the margin is now Rs 4 per note book." GITMR supplemented, "may be on day 4, the shop where Flowers sells would down the price by Rs 1 to Rs 23 to see what Flowers would do".
Neta (becoming a politician was his dream) stood up. "Before long the two shopkeepers, acting independently without even knowing the existence of each other, would have upped and downed their respective prices such that Flowers wouldn't have any more free killing. And once that happens Flowers would come back to the class". The class roared.
Chatshow was happy at the way the discussion was progressing. "Yes, money isn't available for jam", he said. "There is no such thing as a money machine. This is what is known as the law of one price." And then added "for prices to equalise all investors don't have to be investment savvy. All that is needed is that enough number of investors have to recognise arbitrage opportunities!"
Goggles (because outside the classroom he was always seen in goggles) wondered whether it was such a profound statement. Was it as profound as Newton's law of gravity? Or as profound as the law of demand and supply that economics so famously preaches? After all there were price mismatches. Two B-schools offered identical curriculum; yet one charged a fee thrice that of the other. But he kept his thoughts to himself.
"Sir, we find arbitrage all over the place". It was GITMR again. "Modigliani and Miller made a fortune using it to develop the Net Operating Income theory," she said. "Two companies having the same EBIT and operating in the same business risk class cannot command two different prices in the marketplace. If they do command, then the process of arbitrage will set in motion and before long the two values will become equal." The class clapped. Chatshow waved them into silence. "Good. But is arbitrage used elsewhere?" he asked.
Boka said, "I don't know what it is called but I guess this arbitrage could be a determinant of exchange rates." The class sat up. They hadn't as yet been taught International Finance. Boka narrated, "If a basket of apples costs Rs 220 in India and $5 in the US, the exchange rate has to be Rs 44 per dollar. Suppose the rate is Rs 45, you could buy a basket in India at Rs 220, sell it in the US for $5, collect Rs 225 (45 x $5) and make a pack of Rs 5 on the deal." There was silent admiration for Boka.
The professor said, "Yup. This is called the purchasing power parity theory." Flowers, who fought for grades with Boka, remarked tongue firmly in cheek, "But sir, which American would eat Indian apples?" Someone giggled. Ignoring the barb and the giggles, the professor proceeded, "The currency of the country where the price is lower will be bought and the currency of the country where the price is higher will be sold. This free flow will soon lead to equalisation of the prices of the baskets in the two countries". And then asked, "Any other examples?"
Flowers decided to speak up. "I guess forward rates need to reflect interest rate differentials". Chatshow didn't like vague statements. "Explain," he snapped. "Suppose the interest rate in India is 10 per cent and that in US is 5 per cent. Suppose you have $100,000 available for investment. Suppose the dollar rate is Rs 40 spot. Suppose this money is invested in the US. It would fetch $105,000 at the year-end. Suppose the amount is converted into rupees; the Rs 40 lakh can be invested at 10 per cent and earn Rs 44 lakh. When this money is repatriated it wouldn't be Rs 40 per dollar. Because in that case people will rush their dollars into India. Instead, the price for the dollar would be Rs 41.90 viz Rs 44 lakh/$105,000."
Chatshow was impressed. "Good" he said. "If that isn't the forward rate, investment in one currency will be more attractive than the other. So capital will flow into the attractive currency, making it appreciate. Soon, the effective returns for investors will be equalised across the two currencies". GITMR startled everybody by saying "High interest rates in one country will be offset by a depreciation in the currency of that country." Chatshow agreed that she could not be more right. And then said, "If the notebook example was a case of arbitrage over space, this one is an example of arbitrage over time."
Goggles wasn't still impressed. He wasn't sure why he had this strange misgiving about the arbitrage theory. He somehow felt it wouldn't be true in every case. And so he asked, "Prof, does it work every time? Take close-ended funds. These when listed in the stock market quote at hefty discounts. Why?"
As Chatshow got ready to answer, the gong went. He promised he would explain it in the next class. In the meantime, as was his wont, the professor suggested that the class should log on to the Net to find some answers.
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