Question

Assume the following bid and ask rates of the pound for two banks as shown below:

​	Bid	Ask
Bank C	$1.61	$1.63
Bank D	$1.58	$1.60

​

As locational arbitrage occurs:

	a.	the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will increase.
	b.	the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will decrease.
	c.	the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will decrease.
	d.	the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.

Answer 1

The correct answer is option d. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.

Locational arbitrage originates when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency. In this case, Bank C's bid price is $ 1.61 > Bank D's ask price = $ 1.60

Hence, there is a locational arbitrage.

As locational arbitrage is exploited, the gap will have to be bridged. Hence, Bank C's bid price will decrease and Bank D's ask price will increase so that the arbitrage stops eventually.

Hnce the correct answer is option d. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.