Question

a) Distinguish between Covered interest Arbitrage and Triangular Arbitrage.

b) You are given these quotes by your bank.

You can sell United States dollars ($) to the bank for 5.10 cedis per $

You can buy United States dollars from the bank for 5.15 cedis per $

The bank is willing to buy euros for 5.75 cedis per euro

The bank is willing to sell euros for 5.85 cedis per euro

The bank is willing to buy Euros for United States dollars for $1.05 per euro

The bank is willing to sell Euros for United States dollars for $1.10 per euro

You have $10,000 and looking to make risk free income

Estimate your profit or loss if you attempt a triangular arbitrage by converting your dollars to Euros, and then convert Euros to Ghanaian Cedis, then convert Ghanaian Cedis to United States dollars

Answer 1

1.

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

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 interest rate parity formula. If transactions costs or other considerations are involved, the excess profit from covered interest arbitrage must more than offset these other considerations for covered interest arbitrage to be plausible