The Foreign Exchange

UNIVERSITY OF CONNECTICUT

SCHOOL OF BUSINESS

October 4th, 2016

Course Name and Number: FNCE 5205 – Global Financial Management

Instructor: Paul Gilson

Prepared by: Fatema Sajjad, Madusree Krishnan, Suchi

Assignment – The Market for Foreign Exchange

1. Solution:

1. To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner Bank at €0.7627/$1.00. This trade would yield €3,813,500= $5,000,000 x .7627. The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.6395/SF1.00, yielding SF5, 963,253 = €3,813,500/.6395. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5,051,036 = SF5, 963,253/1.1806, yielding a triangular arbitrage profit of $51,036.

b. If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of euros, the trade would yield SF5, 903,000 = $5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for €3,774,969= SF5, 903,000 x .6395. The euros would be resold to Dresdner Bank for $4,949,481 = €3,774,969/.7627, or a loss of $50,519. Thus, it is necessary to conduct the triangular arbitrage in the correct order.

c. The S (€/SF) cross exchange rate should be .7627/1.1806 = .6460. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit results from the triangular arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only €0.6395/SF1.00 instead of the no-arbitrage rate of €0.6460/SF1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros. That is, each Swiss franc is sold for €0.6395/SF1.00 instead of the higher no-arbitrage rate of...