Suppose $1 = 0.85 euros in New York, 1 euro = 150 yen in Paris, and 1 yen = $0.008 in Tokyo.a. If you begin by holding $1, how could you profit from these exchange rates? What is your arbitrage profit per dollar initially traded?b. Identify the forces at work that will make the exchange rates consistent with each other in this situation. That is, what forces will lead to a situation in which no profitable arbitrage is possible?
What will be an ideal response?
POSSIBLE RESPONSE:
a. With $1, one should buy 0.85 euros in New York. Then, 0.85 euros should be exchanged for 127.5 yen in Paris. Then, convert 127.5 yen back to dollars in Tokyo, which makes $1.02, yielding a profit of $0.02.
b. The forces of demand and supply will eliminate the arbitrage opportunity. For instance, given the other two exchange rates, this could happen if the extra supply of euros (and extra demand for yen) in Paris drives the euro in Paris to depreciate, so that the yen per euro exchange rate settles at about 147 yen per euro.
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