Question
(Slightly tricky). Recall the law of one price is the idea that securities (or baskets of securities) with identical payoff must have identical prices. In
(Slightly tricky). Recall the law of one price is the idea that securities (or baskets of securities) with identical payoff must have identical prices. In short, the same thing must not have two different costs. Is there a violation of law of one price in the following scenario? There are three currencies, dollar ($), euro (), and yen (U). You can easily convert one into another at the following exchange rates: $2 = 1; $1 = U100; 1 = U150. (Remember the transaction can go either way. For instance, you can convert any $X into X/2, or any X into $2X.) If you think there is no violation, please justify your answer with explicit calculations. If you think there is a violation, in addition to justifying your answer, please also construct a hypothetical trading strategy to take advantage of the violation.1
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