Question

2. Arbitrage and spot exchange rates

Suppose you trade dollars and euros for a bank that has branches in Boston and Rome. You can electronically transfer the funds between the two branch locations at no cost, and trading commissions are negligible. The current dollar-per-euro exchange rate in Boston is E$/EURBO=1.5653

, while in Rome, it is E$/EURRO=1.586.

You can make a profit for the bank if you buy euros in [Rome / Boston ]  and sell them in [Rome / Boston ]   .

Assuming other foreign exchange traders face the same exchange rates you do, they will buy dollars in  [Rome / Boston ] and sell them in [Rome / Boston ]   . As a result, the dollar-per-euro exchange rate in Rome (E$/EURRO) will [fall / rise]   , and the dollar-per-euro exchange rate in Boston (E$/EURBO) will  [fall / rise] .

Answer 1

You can make a profit for the bank if you buy euros in [Boston]  and sell them in  [ Rome]. This happens since the dollar per Euro exchange rate is currently higher in Rome.  It is 1.586 dollars per Euro in Rome whereas it is only 1.5653 dollars per Euro in Boston. So, you can spend 1.5653 dollars to buy one Euro in Boston and sell it for 1.586 in Rome, thereby making a profit of $ 0.0207.

Assuming other foreign exchange traders face the same exchange rates you do, they will buy dollars in  [Rome] and sell them in [Boston ]   . As a result, the dollar-per-euro exchange rate in Rome (E$/EURRO) will [fall]   , and the dollar-per-euro exchange rate in Boston (E$/EURBO) will  [rise] .

As the dollar per Euro rate is higher in Rome when compared to Boston, foreign exchange traders will start buying dollars from Rome and selling them in Boston in order to make profits. This will increase the demand for dollar in Rome which inturn increases its price relative to Euro, causing the dollar-per-euro exchange rate in Rome (E$/EURRO) to fall ( It means that dollar will start appreciating in Rome). Similarly, because of increased supply of dollar in Boston, its its price relative to Euro falls, causing the dollar-per-euro exchange rate in Boston (E$/EURRO) to rise ( It means that dollar will start depreciating in Boston)