Question

Suppose you get the following quotes from Bank A and B on Euro.

           

Bank A            Bid Ask     Bank B         Bid                   Ask

USD1.2610/EU USD1.2630/EUR USD1.2640/EUR USD1.2660/EUR

You realize that you can use local arbitrage to take advantage of the quotes difference. If you could put as much as $1 million into the arbitrage, how much would be your arbitrage profits? To get full credits, you need to include step by step instructions on how to carry out this strategy.

Answer 1

Given

		Bid	Ask
Bank A	1 USD	1.261 Euro	1.263 Euro
Bank B	1 USD	1.264 Euro	1.266 Euro

Step 1 If we have $1 million then our strategy is buying from one bank that has offers us lesser buying price and sell at bank that offfers us higher sale rate.

so if we have  $1 million we need to sell USD and get EURO so we need to consider bid rates of banks

if we sell in BankA we get =1000000*1.261 Euro=1261000Euro

if we sell in BankB we get =1000000*1.264 Euro=1264000 Euro

So it is better to sell in Bank B so that we can get 3000 Euro extra and total 1264000 Euro

now we have 1264000 Euro we need to buy USD

So if we buy at BankA we get =1264000 /1.263=1000791.76 USD

So if we buy at BankB we get =1264000 /1.266=998420 USD

So it is better to buy in Bank A so that we can get 2371 USD extra and total 1000791.76 USD

So totally we receive = 1000791.76 USD-1000000 USD= 791.76 USD as arbitrage profit