Question

Suppose the current bid and ask spot rate quotes are:

$/€: 1.2621 – 25

$/£: 1.9135 – 41

What cross rate bid and ask quotes in terms of £/€ do these prices suggest? (6 points)

BONUS: Suppose a dealer provides cross-rate bid and ask quotes of £/€: 0.6650 – 70 Do these quotes suggest an arbitrage opportunity? If so, describe the strategy to exploit the opportunity and calculate the arbitrage profits. Start by borrowing 1,000 units in one currency and show that at the end of your trades you have more than you borrowed. (10 points)

Answer 1

Cross rate bid ask Pound/ Euro=

bid =1.2621/1.9141 =0.6594

ask=1.2625/1.9135=0.6598

rate quoted by dealer=0.665/0.6670

Yes the quotes suggest that an arbitrage opportunity exists.

Lets start by borrowing Euro 1000.

We sell the euro with the dealer at 0.665, getting 1000*0.665 pounds= 665 pounds

we can sell this pound at Pound/euro ask rate of 0.6598, getting us 665/0.6598 euros=Euros 1007.90

Hence arbitrage profit=amount now-amount borrowed=Euros 1007.9-1000=Euros 7.9.