Question

Damelin Bernard is a foreign currency dealer who is provided with the following information:

        Euro/U.S. dollar = €0.8518/$

        British pound /U.S. dollar = £0.7548/$

        British pound/Euro = £0.8863/€

2.1. Ignoring transaction costs, is there any arbitrage opportunity based on these quotes?

          a.       Yes, because the Pound is overvalued in the £0.8863/€ quote.

          b.       Yes, because the Pound is undervalued in the £0.8863/€ quote. (Correct)

            c.         No arbitrage opportunity exists

the answer for actual is 0.7568*1/0.8518=0.8861 >theoretical is overvalue. why answer is B?

Answer 1

British pound /U.S. dollar * U.S. dollar/Euro = £0.7548/$ /€0.8518/$ = £0.8861/€

Obvioulsy,People will exploit this arbitrage opportunity and the value of British pound/Euro will change to £0.8861/€ which means that Euro will get depreciated (or pound will get appreciated). Hence Pound is undervalued .

The correct answer is  b.       Yes, because the Pound is undervalued in the £0.8863/€ quote.

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