Suppose in New York £/$ = 1, while in Tokyo ¥/$=2.5, but in London £/¥ = 0.50. (a) (2) Is there any profit that could be made with a triangular arbitrage action? If so, describe an example of how such a profit may be earned and what the profit would be. Start with either buying or selling ¥1,000,000 in London. (b) (2) What will happen to the dollar-pound exchange rate and cross rates after arbitrageurs notice this profit opportunity?

(a) Yes, there is a profit by making triangular arbitrage action. Profit starting with selling ¥1,000,000 in London will be ¥250,000. Detailed description is in explanation part.

(b)

The dollar-pound exchange rate will change in the way that pound will be depreciated because there is more supply of pound in New York market following a arbitrageur action as they notice the profit-making opportunity.

Cross rates after arbitrageurs notice will be adjusted to the point where there is no arbitrage opportunity occurs. In (a) example, keeping other exchange rate unchanged, the dollar-pound exchange rate will be adjusted to £/$ = 1.25.

Explanation:

(a)

Investor sell ¥1,000,000 in London to get £500,000 ( exchange rate £/¥ = 0.50).

Further, he sells these £500,000 in New York to get $500,000 ( exchange rate £/$=2.5)

Next, they sell $500,000 to get ¥1,250,000 in Tokyo ( exchange rate ¥/$=2.5)

=> Net profit is ¥1,250,000 - ¥1,000,000 = ¥250,000

(b)

Details have already been explained in the answer part.

a) There are arbitrage opportunities using triangular arbitrage

b)The bank in will realise arbitrage opportunity and adjust the qoute  accordingly

Explanation:

New York £/$=1  Tokyo ¥/$ = 2.5 London £/¥ =0.5

According to cross rates this should be 1/2.5 = 0.4 therefore there are arbitrage opportunities and would be exploited by

Sell 1000000¥  in London since it is overpriced and receive £500000 (1000000*0.5)

Sell £500000 in New York and receive $500000  (£/$=1)

Sell $500000 in Tokyo and receive ¥1250000 ($500000*2.5)

Therefore the profit is ¥1250000-¥1000000=¥250000

b) The bank will adjust qoute  of New york will Raise the dollar pound exchange to 1.25 and the cross rate will remain at 2.5 (£/¥=1.25/2.5=0.5)

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