Suppose in Zurich £/$ = 0.5, while in New York SF/$ = 2.5, but in London £/SF = 0.1
(a) Is there any arbitrage profit that could be made with a triangular arbitrage action? Describe an example of how such a profit may be earned.
(b) What would you guess about the relationship between the dollar rates and cross-rates after arbitrageurs notice this profit opportunity?
(a) Buy SF 1 million in London for £190,000
Use it to buy $ in New York, so that SF 1m = $400,000.
Buy pounds in Zurich so that $400,000 = £200,000
200,000 - 190,000 = £10,000 profit
(b) We expect the gap between rates to close as arbitrageurs buy pounds in Zurich and sell in London through the New York market, i.e., the relationship between rates is restored where cross-rates yield no potential profit.
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