Consider the following direct quotes on the Euro EUR:USD (quotesare for 100,000 Euros):
Bid Ask Bid Ask
Bank A: 1.1265 1.1267 Bank B: 1.1261 1.1263
1) How would you be able to use LocationalArbitrage to make a profit and what would your profit be?

Execute a buy of 100,000 Euros from Bank B at $1.1263/1EUR andimmediately execute a sell of 100,000 Euros to Bank A at$1.1265/1EUR. Your profit will be $20.
2) What would happen to the next price quotesfrom Bank A and Bank B?
The ask price from Bank B would rise and the Bid price at Bank Awould fall, until there is no opportunity for an arbitrageprofit.

Foreign Currency Triangular Arbitrage:
Triangular Arbitrage: Cross rates for all currencies will bein equilibrium due to triangular arbitrage.
Bid Ask
Bank: #Cad/ 1 USD = 1.03255 1.03285
#JPY/ 1 USD = 107.455 107.474
Cross Rate # Cad/ 1 JPY = .009607 .009612
Here we are looking at the indirect rates on the Canadian dollarand the Japanese Yen. Notice, in theory, the cross rate forthe value of the Japanese Yen in terms of Canadian dollars arefound by using the indirect bid rate on the Canadian dollar dividedby the indirect ask rate on the Japanese Yen. Triangulararbitrage is a little more complicated in that theoretically, anybid or ask on currencies relative to the dollar and any bid or askon the cross rates from any bank will be in equilibrium. IFyou were to find a cross rate quote that was not in equilibrium,there would exist an opportunity for triangular arbitrage and thatopportunity would disappear as quotes adjusted.

Covered Interest Arbitrage and Interest Rate Parity:
Covered Interest Rate Arbitrage is the process of capitalizing onthe interest rate differential between two currencies whilecovering your exchange rate risk with a forward contract. Theforward premium (Forward Rate – Spot Rate)/ Spot Rate isapproximately equal to the difference in interest rates over thesame period (interest rates US – interest rates ForCurrency), wherethe Forward and Spot rate are given as a direct quotes(#US$/1ForCurrency).
Interest rate parity:
Covered interest arbitrage is not possible for points along the IRPline. US investors benefit in situations below the IRP line. Foreign investors benefit in situations above the IRPline.
Example Problems:
1) Assume the bid rate of a New Zealand dollar is$.646 while the ask rate is $.648 at Bank X. Assume the bidrate of the New Zealand dollar is $.642 while the ask rate is $.644at Bank Y. Given this informa¬tion, what would be your gainif you use $100,000 and execute locational arbitrage? Thatis, how much will you end up with over and above the $100,000 youstarted with?

$________________
2) National Bank quotes the following for theBritish pound and the New Zealand dollar:

Quoted Bid Price Quoted AskPrice
Value of a British pound (£) in $ $1.255/1£ $1.259/1£
Value of a New Zealand dollar (NZD) in $ $.752/1NZD $.757/1NZD
Value of a British pound in
New Zealand dollars NZD1.681/1GBP NZD 1.695/1GBP

What should the Cross be between the British pound and NZD interms of # of NZD per 1 GBP.
Bid Ask

________________ ________________

Assume you have $100,000 to conduct triangular arbitrage. What isyour profit from implementing this strategy?

$_____________________________
3) Assume the following information:
Current spot rate of New Zealand dollar = $.615
One-year forward rate of the New Zealand dollar = $.625
Annual interest rate on New Zealand dollars = 2.3%
Annual interest rate on U.S. dollars = 2.8%

a) Given the information in this question, theadditional profit from covered interest arbitrage by U.S. investorswith $100,000 to invest is equal to $__________________________
b) Would Covered interest Arbitrage work for aNew Zealand investor with 100,000 NZD to invest?

4) Assume the following information:
Current spot rate of MXP = $0.10
One-year forward rate of the MXP = $0.098
Annual interest rate on MXP = 6%
Annual interest rate on U.S. dollars = 4.8%
a) Given the information in this question, theadditional profit from covered interest arbitrage by a MexicanInvestor with 100,000 MXP to invest.
_________________________Pesos
b) Would covered interest arbitrage work for a USinvestor with $100,000 to invest?
5) National Bank quotes the following for theEuro and the Peso:

Quoted Bid Price Quoted AskPrice
Value of a Euro in $ $1.125/1EUR $1.127/1EUR
Value of a Peso in $ $.055/1Peso $.058/1NZD
Value of a Euro in
Pesos MXN 21/1EUR MXN22/1EUR

What should the Cross be between the Euro and Peso in terms of #of Peso per 1 Euro
Bid Ask

________________ ________________

Assume you have $100,000 to conduct triangular arbitrage. What isyour profit from implementing this strategy?

$_____________________________