CHAPTER 4

EXCHANGE RATE DETERMINATION AND RELATED ISSUES

1. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.56
London (GBP/AUD) 0.35
(a) Is there a possibility for two-point arbitrage?
(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?
Solution
(a) To find out whether there is a possibility for two-point arbitrage, we check if the
equilibrium condition is violated and for that we need to invert one of the rates. The
AUD/GBP rate in London is 2.8571 (calculated as 1/0.35), which is different from the
rate in Sydney. Hence, the equilibrium condition is violated.
(b) Since the AUD/GBP exchange rate is higher in London than it is in Sydney, it follows
that the pound is more expensive in London. Hence, arbitragers will buy the pound in
Sydney and sell it in London. As a result, the exchange rate will rise in Sydney and fall in
London until the rates are equal in both financial centres, at which time arbitrage will
come to an end.
(c) Profit is measured as the difference between the selling rate and the buying rate.
Hence, the profit (measured in Australian dollars per pound bought and sold) is
2.8571  2.5600 0.2971
2. The following exchange rates are quoted simultaneously in Sydney, Frankfurt and
Zurich:
AUD/EUR 1.6400
CHF/AUD 0.8700
CHF/EUR 1.4600
(a) Is there a possibility for two-point arbitrage?
(b) Is there a possibility for three-point arbitrage?
(c) If so, what is the profitable sequence?
(d) What is the profit earned from arbitrage?

Solutions Manual t/a International Finance: An Analytical Approach 2e by Imad Moosa 4–1
(e) How do the three exchange rates change as a result of arbitrage?
(f) What is the value of the CHF/EUR exchange rate that eliminates the possibility for
profitable arbitrage?
Solution
(a) There is no possibility for two-point arbitrage since the exchange rates are equal
across financial centres.
(b) A possibility for three-point arbitrage exists if the equilibrium condition of the
consistency of cross exchange rates is violated. The equilibrium condition is given by
Equation (4.6) as
S (CHF / AUD)
S (CHF / EUR) 
S ( EUR / AUD)
 S (CHF / AUD) S ( AUD / EUR) 0.8700 1.6400 1.4268
Since the calculated CHF/AUD rate is different from the rate that is actually quoted
(1.4600), it follows that there is a possibility for three-point arbitrage.
(c) Suppose that we start with one Australian dollar. Selling the Australian dollar against
the euro produces (1/1.6400) or 0.6098 euros. This amount of euros is sold against the
Swiss franc to obtain ( 0.6098 1.4600) or 0.8903 francs. The Swiss franc amount is sold

against the Australian dollar to obtain ( 0.8903 / 0.8700) or 1.0233 Australian dollars.
Hence, the profitable sequence is AUD  EUR  CHF  AUD.
(d) An arbitrager starting with one Australian dollar will end up with 1.0233 dollars.
Hence, the profit earned per Australian dollar is AUD0.0233, or 2.33 cents.
(e) Selling the Australian dollar against the euro leads to a rise in the AUD/EUR rate.
Selling the euro against the Swiss franc leads to a fall in the CHF/EUR rate. Selling the
Swiss franc against the Australian dollar leads to a rise in the CHF/AUD rate.
(f) The value of the CHF/EUR rate that eliminates the possibility for profitable arbitrage
is calculated in (b) as 1.4268. It is easy to verify that there is no profitable sequence at
this exchange rate.
3. The dealers’ demand and supply functions are:
Qd 10  2. 5Sb
Qs 5 3.5Sa

Solutions Manual t/a International Finance: An Analytical Approach 2e by Imad Moosa 4–2
where Qd and Qs are the quantities supplied and demanded by dealers. The customers’
demand and supply functions are:
Qd 12  2. 3Sa
Qs 2 4. 2 Sb
Calculate the bid-offer spread.
Solution
The bid rate is calculated from the dealers’ demand function and the customers’ supply
function. By equating supply and demand we obtain
10  2.5S b 2 4.2 S b

which can be solved to obtain

8
Sb  1.1940
6.7
Similarly, the offer rate is calculated from the customers’ demand function and the
dealers’ supply function. By equating supply and demand we obtain
12  2.3S a 5 3.5S a

which can be solved to obtain

7
Sa  1.2069
5.8
Therefore, the bid-offer spread is
1.2069  1.1940 0.0129 , or 129 points
4. The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.5575–2.5625
London (GBP/AUD) 0.3475–0.3525
(a) Is there a possibility for two-point arbitrage?
(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?
(d) Compare the results with those obtained from Problem 1 above.
Solution
(a) Arbitrage is triggered by the violation of the equilibrium condition in the presence of
bid-offer spreads. In order to check whether or not this condition holds, we must first
calculate the bid AUD/GBP rate in London. The bid rate is calculated as

Solutions Manual t/a International Finance: An Analytical Approach 2e by Imad Moosa 4–3
 1 1
S b ( AUD / GBP)   2.8369
S a (GBP / AUD) 0.3525
which is different from the offer rate in Sydney, implying the violation of the equilibrium
condition and the presence of profitable arbitrage operation.
(b) Arbitragers will buy the pound in Sydney at the offer rate of 2.5625 and sell it in
London at the bid rate of 2.8369.
(c) Profit earned per pound is
2.8369  2.5625 0.2744
(d) It is obvious from the comparison of the results that arbitrage is less profitable in the
presence of the bid-offer spread (Problem 1).
5. The following exchange rates were reported by Westpac Banking Corporation on 20
November 2002:
JPY/AUD 67.16
GBP/AUD 0.3484
CHF/AUD 0.8012
CAD/AUD 0.8711
(a) Calculate all possible cross rates.
(b) Using the calculated cross rates, show that there is no opportunity for three-point, four-
point or five-point arbitrage.
(c) If the cross rates were 10 per cent higher than those obtained in (a) above, show that
there are opportunities for profitable three-point, four-point or five-point arbitrage.
Solution
(a) The cross rates are as follows:
JPY/GBP 192.77
JPY/CHF 83.82
JPY/CAD 77.10
GBP/CHF 0.4348
GBP/CAD 0.4000
CHF/CAD 0.9198
(b) Starting with one unit of any currency, if you end up with one unit of the same
currency after going through two, three or four currencies, then there is no arbitrage
opportunity. Consider three-point arbitrage involving AUD, JPY and GBP, starting with
one AUD:

Solutions Manual t/a International Finance: An Analytical Approach 2e by Imad Moosa 4–4
• Selling one AUD against the JPY gives JPY67.16.
• Selling JPY67.16 against the GBP gives GBP0.3484.
• Selling GBP0.3484 against the AUD gives one AUD.
Similarly, four-point arbitrage and five-point arbitrage starting with one AUD give the
following:
AUD1.00→JPY67.16→GBP0.3484→CAD0.8710→AUD1.00
AUD1.00→JPY67.16→GBP0.3484→CAD0.8710→CHF0.8012→AUD1.00
(c) If the JPY/GBP exchange rate were 10 per cent higher, it would be 212.05. At this
rate three-point arbitrage would produce the following:
AUD1.00JPY67.16GBP0.3167AUD0.9091
which is not the profitable sequence. Hence, the profitable sequence would be
AUD1.00GBP0.3484JPY73.88AUD1.1001
6. The spot exchange rate between the Australian dollar and the Swiss franc (CHF/AUD)
is 0.8500–0.8580. A speculator believes that the Swiss franc will appreciate, and so buys
CHF1,000,000. Two days later, the exchange rate turns out to be 0.8200–0.8280.
Ignoring the interest rate factor, answer the following questions:
(a) What will the speculator do?
(b) How much profit will the speculator make?
(c) Assuming that the speculator could buy and sell at the mid-rates, calculate the
profit/loss in this case. Comment on your results.
(a) The corresponding AUD/CHF exchange rates are 1.1655–1.1765 and 1.2077–1.2195,
respectively. The speculator buys the Swiss franc at the offer rate of 1.1765. Two days
later the speculator can sell at the bid rate of 1.2077. Assuming that the speculator wants
to realise profit, the Swiss franc will be sold at 1.2077.
(b) The profit realised by buying and selling CHF1,000,000 is
1,000,000 (1.2077  1.1765)  AUD31,200
(c) The mid-buying and selling rates are 1.1710 and 1.2136. If the speculator can act on
these rates, the profit realised will be
1,000,000 (1.2136  1.1710) AUD42,600
It is obvious that the profit realised is lower in the presence of the bid-offer spread.

Solutions Manual t/a International Finance: An Analytical Approach 2e by Imad Moosa 4–5