Question

The following table shows the foreign exchange quotation of two different banks

Bank X Bid price of US dollars GH¢5.40 Ask price of US dollars GH¢5.45

Bank Y GH¢5.39 GH¢5.44

a) Given the above information, briefly explain whether locational arbitrage is possible or not. If it is possible, explain the steps involved in taking advantage of the locational arbitrage, and compute the profit from this arbitrage if you had one million Ghana Cedis (GH¢1,000,000).

b) Calculate the bid/ask spread for each bank and explain any two (2) factors that could account for any difference.

Answer 1

Going by the above information in the question, Locational Arbitrage is POSSIBLE

Locational Arbitrage is a strategy in which a trader/individual seeks riskless profit from differences in the exchange rate for the same currency offered by different banks. Usually, this type of difference is rare and short-lived because the algos detect it very quickly and trade in a matter of seconds by exploiting the arbitrage opportunity, which is not possible for humans to act on it swiftly.

There are simple steps involved in this type of arbitrage, that are buying currency from one bank on BID price and selling it to another bank on its ASK price. This step will be repeated by trader for both the banks.

CALCULATION:

BANK X

Bid price of US dollars = GH¢5.40

Ask price of US dollars = GH¢5.39

Bank Y

Bid price of US dollars = GH¢5.45

Ask price of US dollars = GH¢5.44

1. Trader will buy GH¢ from Bank X at 5.40 and sell it to Bank Y at 5.44

Minimum profit = 5.44 - 5.40 = 0.04

Total Profit for GH¢1,000,000 will be = 0.04 x 1,000,000 = GH¢ 40,000

2. Trader will buy GH¢ from Bank Y at 5.45 and sell it to Bank X at 5.39

Minimum profit = 5.45 - 5.39 = 0.06

Total Profit for GH¢1,000,000 will be = 0.06 x 1,000,000 = GH¢ 60,000

OVERALL PROFIT = GH¢ 40,000 + GH¢ 60,000 = GH¢ 100,000

Bid Ask Spread is the difference between the Bid and Ask Price of the same bank.

Bid-Ask Spread for Bank X = 5.40 - 5.39 = 0.01

Bid-Ask Spread for Bank Y = 5.45 - 5.44 = 0.01

Two factors influencing Bid Ask spread are Liquidity in the market and the difference in demand and supply of the currency and also during the time of uncertainties which generally increases the spread.