Introduction to Finance

Political risk
is the risk associated with the possibility that a national government might 
confi scate or expropriate assets held by foreigners. A nation with relatively lower political 
risk will generally have a relatively stronger currency. 
Economic risk
is the risk associated 
with the possibility of slow or negative economic growth, as well as variability in economic 
growth. A nation that has a relatively higher economic growth rate, along with growth stabil-
ity, will generally have a stronger currency. Furthermore, a nation with a relatively stronger 
economic growth rate will attract more capital infl ows relative to a nation growing more 
slowly. For example, a stronger U.S. economy relative to the eurozone member economy will 
cause investors in both countries to switch from euro investments to dollar investments.
Arbitrage
Arbitrage
is the simultaneous, or nearly simultaneous, purchasing of commodities, securities, 
or currencies in one market and selling them in another where the price is higher. In inter-
national exchange, variations in quotations among countries at any time are quickly brought 
into alignment through the arbitrage activities of international fi nanciers. For example, 
if the exchange rate for a euro was reported in New York at €1 = $1.14 and in Brussels, 
Belgium, at €1 = $1.13, alert international arbitrageurs simultaneously would sell claims 
to euros in New York at the rate of $1.14 and would have Brussels correspondents sell claims 
on U.S. dollars in Brussels at the rate of $1.13 for each euro. Such arbitrage would be prof-
itable only when dealing in large sums. Under these circumstances, if an arbitrageur sold 
a claim on €100 million in New York, $114 million would be received. The corresponding 
sale of claims on American dollars in Brussels would be at the rate of €100 million for $113 
million. Hence, a profi t of $1 million would be realized on the transaction. A quotation 
diff erential of as little as one-sixteenth of one cent may be suffi
cient to encourage arbitrage 
activities.
The ultimate eff ect of large-scale arbitrage activities on exchange rates is the elimination 
of the variation between the two markets. The sale of large amounts of claims to American 
dollars in Brussels would drive up the price for euros, and in New York the sale of claims to 
euros would force the exchange rate down.