Question

Around 1900, a small town on the U.S.-Mexican border was experiencing a strange currency exchange situation. On the Mexican side of the border, a U.S. dollar was only worth 0.90 Mexican peso (1 USD = 0.90 MXN), while on the U.S. side, a Mexican peso was only worth ninety U.S. cents (1 MXN= 0.90 USD). In other words, the citizens of both countries discounted the other country's currency by ten percent.

In this particular town, the international border ran right down the center of the main street, and there were bars on both sides catering to workers from the surrounding area. One Saturday, an American worker rolled into town with little money (only U.S. $1.00) but lots of financial cunning. He stopped at the first bar he found on the U.S. side of the street, ordered himself a ten-cent beer, paid with his U.S. dollar, and asked for a Mexican peso in change (worth only U.S. $.90, remember). After finishing his beer, he walked across the street to a Mexican bar, ordered another ten-cent beer, paid with the Mexican Peso, and asked for a U.S. dollar in change (there, worth only Mexican Peso $.90). Back he went to the American side for another beer, then back across to the Mexican side -- and so on all afternoon and evening, finally staggering back to his camp after a final drink from a Mexican bar and a U.S. one-dollar bill in change -- just as he had started out with.

Use the exchange rate theory to explain why this worker had free beer. Share your thoughts.(50 word minimum)

Answer 1

In USA , 1USD=.90 MXN

In Mexico 1 MXN = .90 USD

The workers in USA bar paid 1 usd. The beer cost 10 cent. So he will get back 90 cent. But he takes mexican peso. And from the exchange rate in us 90 cent is worth 1 mexican peso. So he gets back 1 MXN.

Now he goes to mexican bar and order same 10 cent beer. So he will get back 0.90 MXN. He pays in MXN and take change in dollar. We know that in Mexico, 0.90 MXN is worth 1 USD. So he gets back 1 dollar.

This same will keep repeating. And after his final drink at mexican bar , the worker will have 1 USD that is exact same amount he had at the beginning of the day.

Economic Theory: We can explain this with exchange rate Arbitrage Theory. In exchange rate arbitration we buy and sell different currencies simultaneously to take benefit of the exchange rate differential that exist is various market.

Arbitrage opportunity arises mainly due to inefficiency of market . In case of controll on purchasing and selling of foreign exchange chance of arbitrage opportunity is very less.