Question

Question 3 The following table shows the foreign exchange quotation of two different banks

Bank X Bank Y

Bid price of US dollars GH¢5.40 GH¢5.39

Ask price of US dollars GH¢5.45 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.

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Answer 1

Arbitrage Gain-

It is buying in one market and selling in another market to get risk-free return or profit.

Bid price-

It refers to the highest price a buyer will pay for a security while in case of bank we can say that it is that price in which bank are ready to pay.

Ask Price-

It refers to the lowest price a seller will accept for a security while in case of bank we can say that it is that price in which bank are ready to sell.

In the above case locational arbitrage is possible

Bid Price= GH5.39*1,000,000 = 5,390,000

Ask Price = GH5.45*1,000,000 = 5,450,000

Profit = 5,450,000-5,390,000

=60,000

Answer-2

Spread- The difference between ask price and bid price is known as spread.

In case of Bank X-

Spread- GH 5.45-GH 5.40

=0.05

In case of Bank Y-

Spread -  GH 5.44-GH 5.39

=0.05

Factor that account for difference are:-

1) The main factor determining the width of the bid-ask spread is the trading volume.

2) Another factor affecting the bid-ask spread is market volatility.