Dr. Doris Geide-Stevenson
Solution - Assignment #2
1. Assume that the following spot exchange rates exist today:
British Pound 1 = $1.50
Canadian Dollar CD$ 1 = $ 0.75
British Pound 1 = CD$ 2
Assume no transaction costs. Based on these exchange rates, can triangular arbitrage be used to earn a profit? Explain. Show some calculations.
No, profitable arbitrage is not possible. If you start with $10,000 and exchange into British Pound, you receive 6,666.6 pounds. These pounds exchange to CD$13,333.3 and back into $10,000.
2. Assume the following information:
Bank X Bank Y
Bid price of New Zealand dollars: $ 0.401 $ 0.398
Ask price of New Zealand dollars: $ 0.404 $ 0.400
Given this information, is locational arbitrage possible? If so, explain the steps that would reflect locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use.
Locational/spatial arbitrage is profitable. One can buy NZ$ from Bank Y at a rate of $/NZ$0.4 and sell each NZ$ at $/NZ$0.401. This generates a profit of $2,500 for each $1 million traded.
b. Based on the information above, what market forces would occur to possibly change the various bank rates? Explain.
At Bank Y, an increase in demand for NZ$ is observed. Thus, Bank Y will increase their ask price of the NZ$. At Bank X, the supply of NZ$ will be high. Thus, Bank X will lower their bid price for the NZ$. These price adjustments will work to eliminate opportunities for profitable arbitrage.