Question

1. You observed the bid rate of a New Zealand dollar is $.6723 while the ask rate is $.6812 at Bank X. The bid rate of the New Zealand dollar is $.6712 while the ask rate is $.6701 at Bank Y. What would be your dollar amount profit if you use $1,000,000 to execute locational arbitrage?

Answer 1

Locational arbitrage is a strategy in which investor can make profit due to different exchange rates offered for various banks for a currency. It is possible when selling rate or ask rate of a currency offered by a bank is less than buying rate or bid rate of same currency offered by another bank

In this question, bid rate offered by Bank X = $0.6723 / New Zealand dollar

Ask rate offered by Bank Y = $0.6701 / New Zealand dollar

As ask rate by Bank Y is less than Bid rate by Bank X, so locational arbitrage is possible

Initial amount with investor = $1000000

Steps in arbitrage and profit calculation

i) As investors always buy at ask price so use $1000000 to buy New Zealand dollar from Bank Y at ask price of $0.6701 / New Zealand dollar. We get

1000000 / 0.6701 = 1492314.58 New Zealand dollars

ii) It is know that investors sell at bid price, so sell 1492314.58 New Zealand dollar to Bank X at bid price of $0.6723 / New Zealand dollar. We get

1492314.58 x 0.6723 = $1003283.092

iii) Dollar profit = 1003283.092 - 1000000 = $3283.092

Hence Dollar amount of profit from locational arbitrage = $3283.092