Show how you can make a triangular arbitrage profit by trading at these prices

ECS3350/ECS3122 Coursework

1.
Students are required to type the answers on the coursework word file, save the
word file and submit it online to Unihub.

2.
Your name and Student ID needs to be
included on the front of your submitted coursework.

3.
Each answer should be short. Do feel
free to make your points, but make them concise and clear. The word limit for answering each
sub-question is 180.

4.
The bold numbers in brackets indicate the maximum marks to be awarded for that
part of the question. The total marks are 30. It contributes to 20% of the final marks.

Student ID:

Student Name:

Question
1:
Are the statements below true or false? Explain the reasons for your answers.

1. A
   country which decides to join a Monetary Union expects an increased
   ability to stabilize its output around the full employment level and keep
   inflation low compared with its initial ability under flexible exchange
   rates. (2.5
   marks)

1. Suppose that the United States is on a bimetallic standard at
   $35 to one ounce of gold and $3 for one ounce of
   silver. If new silver mines open and flood
   the market with silver, the two metals will circulate as before in
   the US since citizens could exchange their gold
   currency for silver currency at any time. (2.5 marks)

1. It
   is impossible for a country to run both current account surplus and
   capital account surplus in the same year. (2.5 marks)

Question
2:
The graph below is the exchange rate of Japanese Yen to US dollar (¥/$) between
August to November 2010. On 15^th Sept, Yen moved from 83 to 85.7 yen
per dollar due to the Japanese authorities’ intervention in the foreign
exchange markets to weaken the value of the yen against the dollar, a day after
the yen hit a 15-year high against the dollar.

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1. Explain
   how did Japanese central bank intervene the exchange rate between Yen and
   Dollar in foreign exchange markets? (1.5 marks)

1. What
   was the government’s justification for the intervention? (2 marks)

1. Did the
   intervention succeed? Explain the reasons for your answer. (4marks)

Question
3:
Assume you are a trader in foreign currencies and you look for arbitrage. From
the quote screen on your computer terminal, you observe the exchange rate
quotations below

Bank Quotations	Rate
Citi Bank :	$1.8501/£
UBS :	$1.3325/€
Barclays Bank :	€1.3469/£

Show how you can make a
triangular arbitrage profit by trading at these prices. (Ignore the ask-bid
spread for this question) Assume you
have £5,000 with which to conduct the arbitrage. (Please note that your answers are worth zero mark if they do not
include currency symbols £, $, €)

a.
Explain what a triangular
arbitrage is. What is a condition that will give rise to a triangular arbitrage
opportunity? (2 marks)

b. What €/£ price will eliminate
triangular arbitrage? (1
mark)

c. How you can make a triangular arbitrage
profit by trading at these prices? What
is the profit? Explain and discuss your calculations. (4
marks)

Question
4: A
fund manager uses the concepts of purchasing power parity (PPP) and the
International Fisher Effect (IFE) to forecast spot exchange rates. He gathers
the financial information as follows:

A
year ago, the spot rate between pound and dollar is $1.70/£. In the past year,
US inflation is 2% and UK inflation is 3.5%. The current spot rate is $1.57/£.

(Please
note that your answers are worth zero mark if they do not include currency
symbols $, £)

a. What is relative PPP?
Calculate the current pound spot rate in dollar that would have been forecast
by PPP. (2 marks)

b. Does the PPP hold in this
case? What could be the reasons for that? (3marks)

c. What is IFE? If the expected
US one-year interest rate is 0.25%, expected UK one-year interest rate is 0.5%,
use IFE to predict the expected pound spot rate in dollar one year from now.
(3marks)