Answer to Question #113358 in Macroeconomics for Kiarah Young

Question

3. Suppose in the foreign exchange market that the following exchange rates hold:
£1 = $2.00 £ = British pound sterling
¥1 = $0.20 ¥ = yen
£1 = ¥12 $ = US dollar
How could an arbitrageur make a profit? Assuming flexible exchange rates, how would arbitrage eliminate their profit possibility? What would happen if exchange rates were fixed at these levels?

Answer 1

Arbitrageur will make profit from the difference in prices at exchange rates.

arbitrageur has 100 yen  

buys dollars for 100 yen

100yen-x$

1yen-0.2$, x=20$

buys pounds

x£-20$

1£0.2$, x=100£

buys yen

100£-x yen

1£-12 yen x=1200

1200-100=1100 profit

Arbitrageur eliminate their profit possibility assuming flexible exchange rates, if he does not apply hedging or currency arbitration in time.If exchange rates were fixed at these levels,it is necessary for the arbitrator to carry out foreign exchange operations according to the above calculations in order to be in profit it is necessary for the arbitrageur to carry out foreign exchange operations according to the above calculations in order to be in profit/