Question #30
Reading: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value
PDF File: Reading 5 Currency Exchange Rates - Understanding Equilibrium Value.pdf
Page: 12
Status: Unattempted
Question
Donna Ackerman, CFA, is an analyst in the currency trading department at State Bank. Ackerman is training a new hire, Fred Bos, a recent college graduate with a BA in economics. Ackerman and Bos have the following information available to them: Spot Rates Bid Price Ask Price EUR/USD EUR1.0000 EUR1.0015 GBP/USD GBP2.0000 GBP2.0100 EUR/GBP EUR0.3985 EUR0.4000 Ackerman and Bos are interested in pursuing profitable arbitrage opportunities for State Bank. What will be the profits from triangular arbitrage, starting with $1,000?
Answer Choices:
A. $243.78
B. $245.65
C. $248.46
Explanation
The EUR/USD and GBP/USD rates imply that the arbitrage free cross rates for the EUR/GBP
are:
bid = €1.000/₤2.0100 = €0.4975
ask = €1.0015/₤2.0000 = €0.5008
Since the cross rates given (€0.3985 − €0.4000) are outside of the arbitrage-free cross
rates, profitable arbitrage is available.
It takes too few euros to buy 1 pound, so we want our arbitrage trades to go in the
direction that will cause us to sell overvalued euros for pounds at the ask rate of €0.4000.
Start with $1,000.
Use the $1,000 to buy euros ($1,000 × €1.000/$) = €1,000.
Use the €1,000 to buy sterling (€1,000 / €0.4000/₤) = ₤2,500.
Use the ₤2,500 to buy dollars (₤2,500 / ₤2.0100/$) = $1,243.78.