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?

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Business

Orlando Kaiser

24 June, 06:08

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?

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Carlos Valencia · Answer 1

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)