Data: Beginning of year
Spot rate of £ = $1.596
Spot rate of Australian dollar (A$) = $.70
Cross exchange rate: £1=A$2.28
One-year forward rate of £1= A$.71
One-year U.S. interest rate = 8.00%
One year British interest rate = 9.09%
One-year Australian interest rate = 7.00%
Determining whether triangular arbitrage is feasible and, if so how it should be conducted to make a profit. Background: Triangular arbitrage is used to capitalize on a discrepancy that might exist in the exchange rates between two currencies whose transactions are conducted in the spot market. i) Developing the cross exchange rate that should exist between the British Pound (£) and the Australian dollar (A$).
Value of a £ in units of A$ = $1.596/$.70 = 2.28
Value of an A$ in units of £ = $.70/$1.596 = 0.44
The value of the British pound in units of Australian dollars is the reciprocal of the value of the Australian dollar in units of the British pound. Since there is no discrepancy in the cross exchange rate quoted Triangular arbitrage is therefore not feasible in this case. When quoting this cross exchange rate the bank in question is exchanging the right amount of A$ for a pound and is asking for the right amount of A$ in exchange for the pound. Had there been a discrepancy between the quoted cross exchange rate and (the calculated one) what it should be then triangular arbitrage could have been feasible. The process of purchasing Pounds (£) with US dollars ($); converting the pounds to A$ and then exchanging the A$ for the US dollars ($) in the spot market would generate more dollars than initially invested. Triangular arbitrage, where it is feasible will continue to take place until cross exchange rates are correctly aligned. Question 2
Using the information in question 1, determine whether covered interest arbitrage is feasible and, if so how it should be conducted to make a profit....