Question

Question 3 The following table shows the foreign exchange quotation of two different banks Bank X Bid price of US dollars GH¢5.40 Ask price of US dollars GH¢5.45 Bank Y GH¢5.39 GH¢5.44 a) Given the above information, briefly explain whether locational arbitrage is possible or not. If it is possible, explain the steps involved in taking advantage of the locational arbitrage, and compute the profit from this arbitrage if you had one million Ghana Cedis (GH¢1,000,000). b) Calculate the bid/ask spread for each bank and explain any two (2) factors that could account for any difference.

Answer 1

The following table shows the foreign exchange quotation of two different banks Bank X Bid price of US dollars GH¢5.40 Ask price of US dollars GH¢5.45 Bank Y GH¢5.39 GH¢5.44 a) Given the above information, briefly explain whether locational arbitrage is possible or not. If it is possible, explain the steps involved in taking advantage of the locational arbitrage, and compute the profit from this arbitrage if you had one million Ghana Cedis (GH¢1,000,000).

Bank X Quote = GH¢5.40: GH¢5.45

Bank Y Quote = GH¢5.39: GH¢5.44

a) Locational Arbitrage

Locational arbitrage involves making profit by buying the foreign exchane in one bank and selling it to another bank in the same location. However, this will be possible only if the ask rate of one bank is lower than the bid rate of another.

In the given question, the ask rate of GH¢5.45 and GH¢5.44 and is higher than both the bid rates of GH¢5.39 and GH¢5.40. Hence, there is no locational arbitrage possible in this question.

To prove with an example:

Amount = GH¢1,000,000

1. Buy USD from Bank X at ask rate of 5.45 and sell to Bank Y at bid rate of 5.39

Equivalent USD from bank X = GH¢1,000,000/5.45 = $183,486.24

Convert USD in Bank Y = $183,486.24*5.39 = GH¢988,990.83

Net Loss = GH¢ 1,000,000 - GH¢ 988,990.83 = -GH¢11,009.17

2. Buy USD from Bank Y at ask rate of 5.44 and sell to Bank X at bid rate of 5.40

Equivalent USD from bank X = GH¢1,000,000/5.44 = $183,823.53

Convert USD in Bank Y = $183,823.53*5.40 = GH¢992,647.06

Net Loss = GH¢ 1,000,000 - GH¢ 992,647.06 = -GH¢7,352.94

Thus, there is loss in both scenarios and there is no locational arbitrage opportunity.

b. Bid and Ask spread:

Bid rate is the rate at which the bank purchases the foreign currency and ask rate is the rate at which the bank sells the foriegn currency. Spread is the difference between the bid rate and ask rate.

Bank X Spread = GH¢ 5.45-GH¢ 5.40 = GH¢ 0.05

Bank Y Spread = GH¢ 5.44-GH¢ 5.39 = GH¢ 0.05

The Bid and Ask spread of both the banks are same and there are no differences.

However, generally bid ask spread differs due to :

1. the volume of currency exchanged in one bank in comparison with another bank basis the demand for the currency. Thus, a bank not having high demand of the currency will have higher spread than the other.

2. the amount of the deal also influences the spread. Thus, where a large transaction with buying and selling of currency is involved, the spread of one bank can differ from the other.