Question

An investment banker has $10,000,000 to invest in the foreign currency market. The dollar-euro exchange rate is quoted as $1.50/ € and the dollar-pound exchange rate is quoted at $1.60/£. If a bank quotes a cross rate of €1.10/£, how much money can she make (in terms of dollars) via triangular arbitrage if she is charged a 2% interest rate on borrowed funds? Round intermediate steps to four decimals.

312,500

112,500

0

1,420,833.33   

Based on the information provided in the previous question, which of the following will occur to eliminate the arbitrage opportunity?

		The euro will appreciate against the dollar.
		The pound will depreciate against the dollar.
		The pound will depreciate against the euro.
		None of the above

Answer 1

First convert $ into pounds

1 pound = 1.6$

? =10,000,000$

=10,000,000/1.6

=6250,000 pounds

Now convert pounds into euro

1 pound = 1.1 euro

=6250,000 pound = ?

=6250,000*1.1

=6875,000 euro

now convert euro into $

1 euro = 1.5$

=6875000*1.5

=10312500$

Thus profit = 10312500-(10,000,000*102%)

=10312500-10,200,000

=112500$

The pound will depreciate against the dollar. If this happens then one will be able to realise less unit of dollar against one unit of pound and thus will eliminate arbitrage opportunity