Question

Assume the following exchange rates
$2.05=£1 in New york
¥410=£1 in London
¥200=$ in Tokyo
a) What kind of arbitrage is illustrated above?
b)Is it possible for the arbitrageur to make profit or not explain in detail
c)If the dollar per pound in New York reduced to $2.00/£1,is it now possible for the arbitrageur to make profit or not?if it is explain precisely how an arbitrageur might be able to make profit?
d) As arbitrage comes, explain precisely how making profits will come to an end?

Answer 1

a) Triangular Arbitrage is illustrated in the situation given. It is also known as cross-currency arbitrage or three-point arbitrage. Triangular Arbitrage is the process of exploiting mispricing across three different currencies.

b) No, it is not possible for arbitrageur to make profit from the current situation. The process is as follows:

Buy $2.05 by giving £1 in New york

Then with those $2.05, buy ¥410 in Tokyo

With those ¥410, buy €1 in London

Ultimately you get back €1 only (with what you initially started)

c) If the dollar per pound in New York is reduced to $2.00/£1, it is now possible for the arbitrageur to make profit. The process is as follows:

Buy €1 by giving away $2 in New York

Then, buy ¥410 by selling that €1 in London

Then, buy $2.05 by giving away those ¥410 in Tokyo

Ultimately you have $0.05 extra after the entire process as profit.

d) As arbitrage comes, profits would become zero. This is because more and more people will demand € in New York sk that they could do the triangular arbitration. When demand of Euro will increase, the exchange rate would ultimately change to $2.05/€

Thus , arbitrage would come to an end.