Question

Follow the trading strategies in the lecture to profit from spatial arbitrage in foreign exchange markets. Assume zero transaction cost for the traders. (£–British pound. $–U.S. dollar. ¥–Japanese yen)

1. 1) Bilateral arbitrage. London: 1£=2$. New York: 1£=2.1$. How to profit from $100? What are the profit and the rate of return? How to profit from L1000? What is the profit rate?

2. 2) Triangular arbitrage. London: 1£=2$. New York: 1$=120¥. Tokyo: 1£=200¥.

   1. How to profit from 1£? What is the profit rate?

   2. How to profit from 1$? What is the profit rate?

   3. How to profit from 200¥? What is the profit rate?

Answer 1

1. To profit from $100, you must exchange dollars for pounds in London and then sell pounds for dollars in New york.

So, If you exchange $100 into pounds in London you will get 100/2= £50. You can exchange this for dollars in New york and you wil get 50*2.1= $105. You get $(105-100)= $5 as your profit. rate of return will be (105-100/100)*100%= 5%

Now if you have £1000 you can exchange pounds for dollars in NEw york and you will get 1000*2.1= $2100 in exchange for £1000. Then you can sell these dollars in London for pounds to get 2100/2= $1050. Your profit will be £(1050-1000)= £50. and rate of profit = (1050-1000/1000)*100%= 5%

2. To profit from £1 we must first exchange £1 for $2 in London. Then exchange $2 to get ¥(120*2)= ¥240 in New York and then exchange ¥240 to get £(240/200)= £1.2 in Tokyo. profit rate will be ((1.2-1)/1)*100%= 20%

To profit from $1, sell dollars for yen in New york to get ¥120, then exchange yen for pounds in tokyo to get (120/200)= £0.6. Then exhcnage £ for dollars in London to get (0.6*2)= $1.2. Profit rate again will be (1.2-1/1)*100%= 20%

IF you have ¥200, exchange them for £ to get £1, then exhcnage £1 to get $2 in London, then exchange $2 in New york to get ¥(120*2)= ¥240. Profit rate will be (240-200/200)*100%= 20%