ABSTRACT
We have based our argument on one-way arbitrage, that is, by considering people who plan to exchange currencies and are looking for the cheaper of two methods: exchange via the foreign exchange market, or exchange via buying, shipping, and selling gold. This is the type of arbitrage we considered when discussing cross exchange rates in Chapter 2 and covered interest parity in Chapter 8. An alternative way of reaching the same conclusion is with round-trip arbitrage, which involves showing that if the exchange rate in our example is not $1.60/£, people can profit by buying gold with domestic money, shipping the gold to the other country, selling the gold for foreign currency, and then selling the foreign currency for domestic money. This is a round trip, starting and ending with domestic currency. When there are no transaction costs, one-way and round-trip arbitrage produce the same result. However, when it is costly to exchange currencies as well as costly to ship, buy, and sell gold, round-trip arbitrage implies an unrealistically large possible range in the exchange rate. Appendix B derives the possible range in exchange rates based on the correct, one-way arbitrage argument. The end points of the possible exchange rate range are called gold points. Exchange rates must be between these points.
