Question

Suppose $1.51 =1 pound in New York and $1.49=1 pound in London. How can foreign exchange arbitrages profit from these exchange arbitrages results in the same dollar/pound exchange rate in New York and London

Answer 1

In the arbitrage process, the participants in the exchange market make risk-less profits by intelligently exploiting price differences of an asset at different dealing locations. There is potential for arbitrage in the forex market if the exchange rates are not consistent between currencies. When price differences occur in different markets, participants purchase foreign exchange in a low-priced market for resale in a high-priced market and makes profit in this process.

In the given case, the dollar price in London is less than its price in New York. So participants purchases pound by giving dollars in the London market and sell the same pound in the New York market for dollars, as a result participants paid 1.49 dollar in the London market and received 1.51dollar in the New York market. Net profit is 0.02 dollar per pound($1.51-$1.49). Total profit would be "no.of pounds bought and sold * profit per pound "

The above arbitrage process will continue until the price in the two markets are equalized or until they differ only by the amount of transaction costs in the operation.