Chapter 11: Problem 10

Suppose $\$ 1.69=£ 1$ in New York and $\$ 1.71=£ 1$ in London. How can foreign exchange arbitragers profit from these exchange rates? Explain how foreign exchange arbitrage results in the same dollar/ pound exchange rate in New York and London.

Short Answer

Expert verified

Foreign exchange arbitragers can profit from these rates by buying pounds in New York and selling them in London, making a risk-free profit. Their activity will eventually drive up the price in New York and push down the price in London, thus equalizing the exchange rates in both locations.

Step by step solution

Identify the arbitrage opportunity

An arbitrage opportunity exists when you can buy something at a lower price in one market and sell it at a higher price in another. In this case, exchange rates present the opportunity. There is a difference in exchange rates: $1.69=£1 in New York, while $1.71=£1 in London.

Exploit the arbitrage opportunity

To exploit this opportunity, buy pounds (£) in New York where the price is lower. Suppose you have $1690, you convert this to £1000 in New York. Then take these £1000 to London.

Sell the pounds in the London market

Now sell these £1000 in the London market where the rate is higher, thus receiving $1710. This would give you a risk-free profit.

Explain how arbitration results in equal exchange rates

As people exploit the arbitrage opportunity, demand for pounds in New York will increase (pushing the price up), and supply of pounds in London will increase (pushing the price down). The process will continue until the exchange rates in both cities are equal, eliminating the arbitrage opportunity.

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Suppose \(\$ 1.69=£ 1\) in New York and \(\$ 1.71=£ 1\) in London. How can foreign exchange arbitragers profit from these exchange rates? Explain how foreign exchange arbitrage results in the same dollar/ pound exchange rate in New York and London.

Short Answer

Step by step solution

Identify the arbitrage opportunity

Exploit the arbitrage opportunity

Sell the pounds in the London market

Explain how arbitration results in equal exchange rates

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