Cover Deals : Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of its dealings with its customers is known as the ‘cover deal’. The purpose of cover deal is to insure the bank against any fluctuation in the exchange rates.
Since the foreign currency is a peculiar commodity with wide fluctuations in price, the bank would like to sell immediately whatever it purchases and whenever it sells it goes to the market and makes an immediate purchase to meet its commitment. In other words, the bank would like to keep its stock of foreign exchange near zero.
The main reason for this is that the bank wants to reduce the exchange risk it faces to the minimum. Otherwise, any adverse change in the rates would affect its profits.
Arbitrage Operations : If perfect conditions prevail in the market, the exchange rate for a currency should be the same at all centers. For example, if US dollar is quoted at Rs. 31.40 in Bombay, it should be quoted at the same rate of Rs. 31.40 at New York. But under imperfect conditions prevailing, the rates in different centers may be different.
Thus at New York, Indian rupees may be quoted at Rs. 31.48 per dollar. In such a case, it would be advantageous for a bank in Bombay to buy US dollars locally and arrange to sell them at New York. Assuming the operation to involve Rs. 10 lakhs, the profit made by the bank would be:
At Bombay US dollar purchased for Rs. 10,00,000 at Rs. 31.40 would be (10,00,000/31.40) US $ 31,847. Amount in rupees realized on selling US $ 31,847 at New York at Rs. 31.48 would be Rs. 10,02,544.
Therefore, the gross profit made by the bank on the transaction is Rs. 2,544. The net profit would be after deducting cable charges, etc., incurred for the transaction.
The purchase and sale of a foreign currency in different centers to take advantage of the rate differential is known as ‘arbitrage operations’. When the arbitrage operation involves only two currencies, as in our illustration, it is known as ‘simple’ or ‘direct’ arbitrage. Sometimes the rate differential may involve more than two currencies.
Such an arbitrage operation which involves more than two currencies is known as ‘compound’ or ‘indirect’ arbitrage.