Tutorial Problem Set 8

Topic: Chapter 11:

International Arbitrage
FM303: International Finance
Week 12-13, Sem. 1, 2019

Question 1. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.5600
London (GBP/AUD) 0.3500

(a) Is there a possibility for two-point arbitrage?

(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?

Q1 Solution
(a) To find out if there is a possibility for two-point arbitrage, we check if the equilibrium condition
is violated and for that we need to invert one of the rates. The AUD/GBP rate in London is 2.8571
(calculated as 1/0.35), which is different from the rate in Sydney. Therefore, the equilibrium
condition is violated.
(b) Since the AUD/GBP exchange rate is higher in London than it is in Sydney, it follows that the
pound is more expensive in London. Therefore, arbitragers will buy the pound in Sydney and sell it
in London. As a result the exchange rate will rise in Sydney and fall in London until they are equal
in both financial centres, at which time arbitrage will come to an end.
(c) Profit is measured as the difference between the selling rate and the buying rate. Therefore, the
profit (measured in Australian dollars per pound bought and sold) is:
2.8571  2.5600  0.2971

Question 2. The following exchange rates are quoted simultaneously in Sydney, Frankfurt and
Zurich:

AUD/EUR 1.6400
CHF/AUD 0.8700
CHF/EUR 1.4600

(a) Is there a possibility for two-point arbitrage?

(b) Is there a possibility for three-point arbitrage?
(c) If so, what is the profitable sequence?
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(d) What is the profit earned from arbitrage?
(e) How do the three exchange rates change as a result of arbitrage?
(f) What is the value of the CHF/EUR exchange rate that eliminates the possibility for profitable
arbitrage?

Q2 Solution
(a) There is no possibility for two-point arbitrage since the exchange rates are equal across
financial centres.
(b) A possibility for three-point arbitrage exists if the equilibrium condition of the consistency of
cross exchange rates is violated. The equilibrium condition is:
S (CHF / AUD)
S (CHF / EUR) 
S ( EUR / AUD)
 S (CHF / AUD)  S ( AUD / EUR)  0.8700  1.6400  1.4268

Since the calculated CHF/EUR rate is different from the rate that is actually quoted (1.4600), it
follows that there is a possibility for three-point arbitrage.

(c) Suppose that we start with one Australian dollar. Selling the Australian dollar against the euro
produces (1/1.6400) or 0.6098 euros. This amount of euros is sold against the Swiss franc to obtain
( 0.6098  1.4600) or 0.8903 francs. The Swiss franc amount is sold against the Australian dollar to
obtain ( 0.8903 / 0.8700) or 1.0233 Australian dollars. Therefore the profitable sequence is AUD 
EUR  CHF  AUD.

(d) An arbitrager starting with one Australian dollar will end up with 1.0233 dollars. So the profit
earned per Australian dollar is AUD0.0233 or 2.33 cents.

(e) Selling the Australian dollar against the euro leads to a rise in the AUD/EUR rate. Selling the
euro against the Swiss franc leads to a fall in the CHF/EUR rate. Selling the Swiss franc against the
Australian dollar leads to a rise in the CHF/AUD rate.

(f) The value of the CHF/EUR rate that eliminates the possibility for profitable arbitrage is
calculated in (b) as 1.4268. It is easy to verify that there is no profitable sequence at this exchange
rate.

Question 3. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.5575-2.5625
London (GBP/AUD) 0.3475-0.3525

(a) Is there a possibility for two-point arbitrage?

(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?

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(d) Compare the results with those obtained from problem 1.

Q3 Solution
(a) Arbitrage is triggered by the violation of the equilibrium condition in the presence of bid–offer
spreads. In order to check whether or not this condition holds, we must first calculate the bid
AUD/GBP rate in London. The bid rate is calculated as:
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S b ( AUD / GBP)    2.8369
S a (GBP / AUD) 0.3525
which is different from the offer rate in Sydney, implying the violation of the equilibrium
condition and the presence of a profitable arbitrage operation.

(b) Arbitragers will buy the pound in Sydney at the offer rate of 2.5625 and sell it in London at the
bid rate of 2.8369.

(c) Profit earned per pound is:

2.8369  2.5625  0.2744

(d) It is obvious from the comparison of the results that arbitrage is less profitable in the presence
of the bid–offer spread (problem 1).

Question 4 (Optional). The following exchange rates are quoted:

JPY/AUD 67.16
GBP/AUD 0.3484
CHF/AUD 0.8012
CAD/AUD 0.8711
(a) Calculate all possible cross rates.
(b) Using the calculated cross rates, show that there is no opportunity for three-point, four-point or
five-point arbitrage.
(c) If the cross rates were 10% higher than those obtained in (a), show that there are opportunities for
profitable three-point, four-point or five-point arbitrage.

Q4 Solution (Refer to lecture notes for example)

(a) The cross rates are as follows:
JPY/GBP 192.77
JPY/CHF 83.82
JPY/CAD 77.10
GBP/CHF 0.4348
GBP/CAD 0.4000
CHF/CAD 0.9198

(b) Start with one unit of any currency. If you end up with one unit of the same currency after
going through two, three or four currencies there is no arbitrage opportunity. Consider three-point
arbitrage involving AUD, JPY and GBP, starting with one AUD:
 Selling one AUD against the JPY gives JPY67.16.
 Selling JPY67.16 against the GBP gives GBP0.3484.
 Selling GBP0.3484 against the AUD gives one AUD.

Similarly, four-point arbitrage and five-point arbitrage starting with one AUD give the following:
AUD1.00→JPY67.16→GBP0.3484→CAD0.8710→AUD1.00.
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AUD1.00→JPY67.16→GBP0.3484→CAD0.8710→CHF0.8012→AUD1.00.

(c) If the JPY/GBP exchange rate was 10% higher, it would be 212.05. At this rate, three-point
arbitrage would produce the following:
AUD1.00JPY67.16GBP0.3167AUD0.9091.
which is not the profitable sequence. Hence the profitable sequence would be:
AUD1.00GBP0.3484JPY73.88 AUD1.1001.

~The End~

RRK/SI/2019/FM303/W12-13TUT