Question

Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. Bank A Bank B Bid price of USD GHS 5.72 GHS 5.55 Ask Price of USD GHS 5.85 GHS 5.65 Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had GHS10 million to use. What market forces would occur to eliminate any further possibilities of locational arbitrage?

Answer 1

Bank A

Ask Price GHS 5.85 (Sells Dollar at this Rate)

Bid Price GHS 5.72 (Buys Dollar at this Rate)

Bank B

Ask Price GHS 5.65 (Sells Dollar at this Rate)

Bid Price GHS 5.55 (Buys Dollar at this Rate)

Now lets understand the Bid Price and Ask Price. Bid price is the price bank is ready to pay for a dollar in GHS while Ask Price is rate at which it is willing to sell dollar. Now for Arbitrage we need to find a combination of Ask and Bid Price where there is a price difference.

It is clearly seen that the Bid price of the Bank A and Ask Price of Bank B gives a window for Arbitrage.

So if I go to Bank A and Sell all the dollar and Bank buys it at GHS 5.72 I receive GHS 57.2 million. Now I go to Bank B sell the GHS to Bank and Bank sells Dollar to me at 5.65 Thus giving 1 dollar for every GHS 5.65 Thus I Receive 57.2/5.65 = $ 10.1238938053 million

The gain is 0.1238938053/10 million

= 1.238938053 %

= 1.24%

As there is a window for arbitrage the traders would like to make profit from the transaction thus increasing demand of GHS would increase price of GHS in Bank A and decrease in price of GHS Ask rate in Bank B because of too much dollar is bought. Thus balancing the prices