Question

You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate is quoted as $1.50 = €1.00 and the dollar-pound exchange rate is quoted at $2.00 = £1.00. If a bank quotes you a cross rate of £1.00 = €1.25 how can you make money? A. No arbitrage is possible. B. Buy euro at $1.50/€, buy £ at €1.25/£, sell £ at $2/£. C. none of the options D. Buy £ $2/£, buy € at €1.25/£, sell € at $1.50/€.

Answer 1

Answer:

B. Buy Euro at $1.50/€, buy £ at €1.25/£  sell £ at $2/£

Explanation:

By calculating the cross rate between  € and £ we see that Euros are undervalued by the bank as they are quoted as 1.25 ,

S(€/£)=S($/£)/S($/€)

           2/1.5

            1.33

so in this case we by Euros convert to pounds and the convert to dollars

Answer 2

Answer:

The correct answer is (B) Buy euro at $1.50/€, buy £ at €1.25/£, sell £ at $2/£

Explanation:

The dollar- euro exchange rate is quoted as $1.50 = €1.00

the dollar-pound exchange rate is quoted at $2.00 = £1.00

To calculate the actual cross rate we use; S(euro divided by pounds) =  S(dollar/pounds) ÷ S(dollar/euro).

Using symbols to denote this, we have S(€/£) = S($/£) / S($/€)

S(€/£) = S(2/1) ÷ S(1.50/1)

= (2 / 1.5)

= €1.33.

Consequently, from this result we now know that the euro is undervalued with respect to pounds under the cross rate being offered by the bank. This implies that you should first buy the euro, convert to pounds, and eventually convert back to dollars, this would enable you make money as an investor.