Question

Arbitrage and spot exchange rates

Suppose you trade dollars and euros for a bank that has branches in Los Angeles and Frankfurt. You can electronically transfer the funds between the two branch locations at no cost, and trading commissions are negligible. The current dollar-per-euro exchange rate in Los Angeles is E$/EURLA=1.5952E$/EURLA=1.5952 , while in Frankfurt, it is E$/EURFR=1.6244E$/EURFR=1.6244. You can make a profit for the bank if you buy euros in________and sell them in_______. Assuming other foreign exchange traders face the same exchange rates you do, they will buy dollars in and sell them in_______. As a result, the dollar-per-euro exchange rate in Frankfurt (E$/EURFRE$/EURFR) will______, and the dollar-per-euro exchange rate in Los Angeles (E$/EURLAE$/EURLA) will________.

Answer 1

1. buy in Los Angeles, sell in Frankfurt

2. buy in Frankfurt; sell in Los Angeles

3. remain unchanged

Step-by-step explanation:

Note that as for me working for the bank I'm buying Euros, in turn to sell to receive the Dollar.

1. Thus, in Los Angeles the exchange rate indicates a profit if it is bought there and sold in Frankfurt where the Euros values more than it does in Los Angeles.

2. For the foreign exchange traders who already own Euros and want to buy dollars, they would make a profit by buying Dollars in Frankfurt where the Euros has greater and value and selling the bought dollars in Los Angeles where the dollar has greater value.

3. This is the case because there's a balance in demand as a result of the arbitrage trading.