Answer the following questions regarding the arbitrage strategies in the foreign exchange markets. a. Suppose that Bank A quotes the exchange rates as: $1.25/ Bid and $1.27/ Ask; and Bank B quotes the FX rates: $1.28/ Bid and $1.29/ Ask given the same time period. Present the location arbitrate strategy and its profit. Assume that you start with 1million. b. Suppose that the exchange rate of E in $ is given:, but all other rates are the same (see Slide #12). First show that the "triangular arbitrage" is possible. Then, present the arbitrage strategies and its profit in. Review lecture notes Slide #11, 12, 13 and 14. 4.2 Exchange Rate Equilibrium Cross exchange rates and triangular arbitrage An example with U.S. dollars ($), Japanese yen (), and Egyptian pounds (E): SEP'$ = E5.000/$ S$ = $0.2000/E SSV = $0.01000/ SW$ = 100.0/$ SWEL = 20.20/E SEDIH E0.04950 SEP$ S$/4 SWE = (E5/$)($0.01/)(20.20/E) = 1.01 > 1 Butler / Multinational Finance e Chapler 4 The International Parity Conditions 4-12 4.2 Exchange Rate Equilibrium Cross exchange rates & triangular arbitrage SER$ S$ SWE = 1.01 > 1 Currencies in the denominators are too high relative to the numerators, so... Sell dollars and buy Egyptian pounds. Sell yen and buy dollars. Sell Egyptian pounds and buy yen. Butler / Multinational Finance 6e Chapter 4 The International Parity Condition 4 13 4.2 Exchange Rate Equilibrium An example of triangular arbitrage Arbitrage profit Sell $1m and buy E5m at E5/$ +E5m = +E50,000 or about 1% of the initial amount Sell $100m and buy $1m at $0.0184 +$1m - 100m Sell E4.95m and buy $100m at 20.20/E + 100m -E$4.95m Butler / Multinational Finance te Chapter 4 The International Parity Conditions 4-14 C. Suppose that the forward rate of in $ is given: , but all other values are the same (see Slide #21). First show that the "covered interest arbitrage" is possible. Then, discuss the arbitrage strategies and its profit in $. 4.3 Interest Rate Parity and Covered Interest Arbitrage Interest rate parity: Which way do you go? If Fat/S, dif> [(1+id)/(1+i")]* then Fall must fall s, d'f must rise id must rise if must fall so... Sell fat Fan Buy f at S, M Borrow at 10 Lend at it Buffer / Multinational Finance e Chapter 4 The International Party Conditions 4-19 4.3 Interest Rate Parity and Covered Interest Arbitrage Interest rate parity: Which way do you go? If F_dIS, d4 (1+i)/(1+i) 1.041667 > 1.038835 The currency and Eurocurrency markets are not in equilibrium. Rurfer / Muminational Finance fe Chapter The International Party Conditions 1-21 4.3 Interest Rate Parity and Covered Interest Arbitrage Covered interest arbitrage 1. Borrow $1,000,000 $1,000,000 at is = 7% $1,070,000 2. Convert $s to s +833,333 at S, = $1.201 $1,000,000 3. Invest s +858,333 at if = 3% 833,333 4. Convert s to $s +$1,072,920 at F, $ve = $1.25/ -858,333 5. Arbitrage profit = $2,920 Butler / Multinational Finance 6e Chapter 4 The International Party Conditions 4-22