Question

Given the following exchange rates 10pts Yen 125/$ DM 2/$ DM .015/Yen Is arbitrage possible? Start your answer with either “yes’ (it is possible) or “no” (it is not possible) and then show why your answer is correct. If arbitrage is possible, show how it could be done?

Answer 1

Yes arbitrage is possible and it will be executed as described below:

- Assume that the world is an interest-free place, which essentially implies that borrowings and deposits will not have any interest payments associated with them.

- Borrow 125 Yen and convert it into $ 1 at the current Yen $ exchange rate.

- Convert the $ into 2 DM at the current DM/ $ exchange rate.

- Further, convert 2 DM into Yen at the current DM / Yen exchange rate to yield (2/0.015) = 133.34 Yen approximately.

- Use the Yen proceeds to pay off the initial Yen borrowing of 125 Yen. Riskless(Arbitrage) Profit = Yen Proceed - Initial Yen borrowing = 133.34 - 125 = 8.34 Yen