A Circulation Network Model for the Exchange Rate Arbitrage Problem

Abstract

In this article a circulation network model for the detection of arbitrage
opportunities in the currencies and securities markets is presented. As an
illustration, the study presents 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 deposit rates 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 represent profits
from arbitrage, and it is obtained through the application of a minimum cost
flow algorithm.