What is arbitrage? Assume that the dollar is quoted $1 = £0.625 in New York and the pound sterling is quoted as
£1 = $1.63 in London.
Is there an arbitrage opportunity? If so, what would an astute trader do? What will
happen to the quotes as trades are made at current prices?
Arbitrage is the simultaneous purchase and sale of an asset in more than one market resulting in a riskless profit. There
is an arbitrage opportunity because the price of a pound in New York is $1.60 and the price of a pound in London is
$1.63. Given the current quotes, an astute investor will buy pounds in New York while simultaneously buying dollars
in London. Example: A $10,000 investment in New York will buy £6,256 ($10,000 × 0.6256). Simultaneously buying
dollars in London yields $10,197.28 (£6,256 × $1.63), a 1.65% gain. Since the transactions are entered simultaneously, no
risk is involved. The sale of dollars in New York for pounds and the sale of pounds in London for dollars will force the
rates back to equilibrium.
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