Question

Q a. Suppose $1.69= £1 in New York and $1.68=£1 in London. How can foreign exchange arbitragers profit from these exchange rates?

Q b. Assume that a speculator anticipates that the spot rate of the franc in three months with be higher than today’s three-month forward rate of the franc, $0.50=1 franc. How can this speculator use $1 million to speculate in the forward market? Please elaborate your answer.

Answer 1

Hi,

Hope you are well!

Question:

Answer:

a). Answer:

Speculator: It may be a person or an organization or firm or a company that acts of buying and selling the foreign currency under the conditions of uncertainty with a view to earning huge gains.

In this question:

Exchange rate in New York =  $1.69= £1

Exchange rate in London =  $1.68=£1

As per the quotation $ is more costly in London than New York so, Speculator will sell  $ in London and buy $ in New York. A specula In this strategy a speculator will earn a profit of - $0.01 by a single unit of buying and selling.

###### Here we have not taken any other expenses.

b). Answer:

The speculators buy the currency when it is weak and sells when it is strong. Also, if the spot rate of the currency is expected to increase in the future, then the speculator buys forward and sell “on the spot” the currency bought by him. Simply if the speculator realize of expect that the spot rate of the currency is expected to increase in the future then speculator will buy forward and sell it in spot market.

As per the question- today’s three-month forward rate of the franc, $0.50=1 franc

Speculator anticipates that the spot rate of the franc in three months with be higher than today’s three-month forward rate.

The speculator has $1 million.

Speculator anticipates that the spot rate of the currency is expected to increase in the future so, the speculator buys forward and sell “on the spot” the currency bought by him.

Example: Suppose the spot rate of the currency in three month is $0.70=1 franc

Then the forward rate is $0.50=1 franc and $0.70=1 franc  

we know that when the Speculator anticipates that the spot rate of the currency is expected to increase in the future so, the speculator buys forward and sell “on the spot” the currency bought by him.

So, the speculator will gain of $0.20 ( on every unit of transaction)

###### Here we have not taken any other expenses.

Thank You