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Solution to ch 7
Answers to End of Chapter Questions
1. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned.
2. Assume the following information:
Bank X Bank Y Bid price of New Zealand dollar $.401 $.398 Ask price of New Zealand dollar $.404 $.400
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use.
ANSWER: Yes! One could purchase New Zealand dollars at Bank Y for $.40 and sell them to Bank X for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Bank Y. These New Zealand dollars could then be sold to Bank X for $1,002,500, thereby generating a profit of $2,500.
3. Based on the information in the previous question, what market forces would occur to eliminate any further possibilities of locational arbitrage?
ANSWER: The large demand for New Zealand dollars at Bank Y will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Bank X will force its bid price down. Once the ask price of Bank Y is no longer less than the bid price of Bank X, locational arbitrage will no longer be beneficial.
4. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.
ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it
Answers to End of Chapter Questions
1. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned.
2. Assume the following information:
Bank X Bank Y Bid price of New Zealand dollar $.401 $.398 Ask price of New Zealand dollar $.404 $.400
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use.
ANSWER: Yes! One could purchase New Zealand dollars at Bank Y for $.40 and sell them to Bank X for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Bank Y. These New Zealand dollars could then be sold to Bank X for $1,002,500, thereby generating a profit of $2,500.
3. Based on the information in the previous question, what market forces would occur to eliminate any further possibilities of locational arbitrage?
ANSWER: The large demand for New Zealand dollars at Bank Y will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Bank X will force its bid price down. Once the ask price of Bank Y is no longer less than the bid price of Bank X, locational arbitrage will no longer be beneficial.
4. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.
ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it