Question

Suppose in New York £/$ = 1, while in Tokyo ¥/$=2.5, but in London £/¥ = 0.50. (a) (2) Is there any profit that could be made with a triangular arbitrage action? If so, describe an example of how such a profit may be earned and what the profit would be. Start with either buying or selling ¥1,000,000 in London. (b) (2) What will happen to the dollar-pound exchange rate and cross rates after arbitrageurs notice this profit opportunity?

Answer 1

Answer:

a) There are arbitrage opportunities using triangular arbitrage

b)The bank in will realise arbitrage opportunity and adjust the qoute  accordingly

Explanation:

New York £/$=1  Tokyo ¥/$ = 2.5 London £/¥ =0.5

According to cross rates this should be 1/2.5 = 0.4 therefore there are arbitrage opportunities and would be exploited by

Sell 1000000¥  in London since it is overpriced and receive £500000 (1000000*0.5)

Sell £500000 in New York and receive $500000  (£/$=1)

Sell $500000 in Tokyo and receive ¥1250000 ($500000*2.5)

Therefore the profit is ¥1250000-¥1000000=¥250000

b) The bank will adjust qoute  of New york will Raise the dollar pound exchange to 1.25 and the cross rate will remain at 2.5 (£/¥=1.25/2.5=0.5)

Answer 2

Answer:

(a) Yes, there is a profit by making triangular arbitrage action. Profit starting with selling ¥1,000,000 in London will be ¥250,000. Detailed description is in explanation part.

(b)

The dollar-pound exchange rate will change in the way that pound will be depreciated because there is more supply of pound in New York market following a arbitrageur action as they notice the profit-making opportunity.

Cross rates after arbitrageurs notice will be adjusted to the point where there is no arbitrage opportunity occurs. In (a) example, keeping other exchange rate unchanged, the dollar-pound exchange rate will be adjusted to £/$ = 1.25.

Explanation:

(a)

Investor sell ¥1,000,000 in London to get £500,000 ( exchange rate £/¥ = 0.50).

Further, he sells these £500,000 in New York to get $500,000 ( exchange rate £/$=2.5)

Next, they sell $500,000 to get ¥1,250,000 in Tokyo ( exchange rate ¥/$=2.5)

=> Net profit is ¥1,250,000 - ¥1,000,000 = ¥250,000

(b)

Details have already been explained in the answer part.