A Circulation Network Model for the Exchange Rate Arbitrage Problem

Abstract

In this article we present a circulation network model for the detection of arbitrage opportunities in the currencies and securities markets. As an illustration we present its application to the interest rate of the Mexican and American bond market, the interbank loan rate of both countries, as well as to the deposits rate of US and Canada reported in Bloomberg. Deviations of covered interest rate parity imply that there exist a series of transactions that can be carried out to obtain riskless profits by exploiting arbitrage opportunities. The problem of finding arbitrage opportunities is modeled via a generalized maximum flow problem. The maximum flow over the generalized circulation network represents profits from arbitrage, and it’s obtained through the application of a minimum cost flow algorithm.

Keywords: arbitrage, currencies markets, circulation netwrok model