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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 XBank 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 should be.  The appropriate cross rate can be determined given the values of the two currencies with respect to some other currency.

5.Assume the following information for a particular bank:

Quoted Price
Value of Canadian dollar in U.S. dollars$.90
Value of New Zealand dollar in U.S. dollars$.30
Value of Canadian dollar in New Zealand dollarsNZ$3.02

Given this information, is triangular arbitrage possible?  If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use.

ANSWER: Yes.  The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars.  Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be.  One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars.  With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667.

[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 × $.30 = $1,006,667]

6.Based on the information in the previous question, what market forces would occur to eliminate any further possibilities of triangular arbitrage?

ANSWER: The value of the Canadian dollar with respect to the U.S. dollar would rise.  The value of the Canadian dollar with respect to New Zealand dollar would decline.  The value of the New Zealand dollar with respect to the U.S. dollar would fall.

7.Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.

ANSWER: Covered interest arbitrage involves the short-term investment in a foreign currency that is covered by a forward contract to sell that currency when the investment matures.  Covered interest arbitrage is plausible when the forward premium does not reflect the interest rate differential between two countries specified by the...
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