International Financial Management Lecture 8 & 9 PDF

International
Arbitrage Part I ITM BUSINESS SCHOOL

F1,F2 & F3 17 – 19
SEMESTER III
Lecture 8 to 9 VIJAYANTA PAWASE
Arbitrage
• Arbitrage can be defined as a operations which
involves a simultaneous purchase and sale of a
asset in order to gain from a price difference.
Arbitrage
• The price difference is possible only if there is an

imperfection in the markets.
• Arbitrage generally defined as capitalizing on a
discrepancy in quoted prices as a result of the
violation of an equilibrium (no-arbitrage)
condition.
• An arbitrageur(a person who does arbitrage) is an

Arbitrageur
entity who identifies an opportunity for arbitrage

An
and initiates transactions so as to benefit from

such an opportunity.
Arbitrage
• Arbitrage operations helps to equalize prices, in the
same are different markets by removing prize
imperfections. Opportunities for arbitrage generally
arise out of the following situations.
Arbitrage Opportunity
• Sudden imbalance in the demand & supply

equilibrium.
• Time zone, Exchange control regulations,
Information.
• The arbitrage process restores equilibrium via
changes in the supply of and demand for the
underlying commodity, asset or currency.
• The importance of arbitrage is that no conditions are
used for asset pricing such that the equilibrium price
of a financial asset is the price that is consistent with
the underlying no-arbitrage condition.
Arbitrage
• Simple arbitrage can be of 2 types;
Arbitrage
Types of
• Two point arbitrage: 2 - point arbitrage is also called as

Geographical arbitrage and it involves 2 currencies.
• Triangular arbitrage: 3 - point arbitrage is also called as
Triangular arbitrage and it involves 3 currencies.
Two Point Arbitrage
Also known as spatial arbitrage or

locational arbitrage, two-point arbitrage
arises when the exchange rate between
two currencies assumes two different
values in two financial centres at the same
time.
We will first consider two-point arbitrage
without the bid—offer spread, then we
modify the operation to account for the
spread.
Two Point Arbitrage
Two-point arbitrage without the bid—offer spread
• Given two financial centres, A and B, and two currencies,

x and y, and assuming (for simplicity) no transaction costs
and a zero bid—offer spread, arbitrage will be triggered if
the following condition is violated:
SA(x/y) = SB(x/y)
• This condition says that the exchange rate between x and
y should be the same in A as in B. If the condition is not
satisfied in the sense that the exchange rate between x
and y is different in A from its level in B, then the
currencies are expensive in one financial centre and
cheap in the other. Arbitragers in this case buy one of the
currencies where it is cheap and sell it at profit where it
is expensive.
Two Point Arbitrage

Two Point Arbitrage
• The arbitrage process restores equilibrium via changes in

the supply of and demand for the underlying commodity,
asset or currency curves for currency y in financial
centres A and B.
• Initially, the exchange rates in A and B are (SA)0 and (SB)o
respectively, such that (SA)0 > (SB)o. As the demand for y
increases in B, to exchange rate rises (y appreciates).
Conversely, the supply of y increases in A and so the
exchange rate falls (y depreciates).
• This process continues until the exchange rates in both
financial centres are equal (that is, until (SA)1 = (SB)1)
because this condition eliminates profit and hence the
incentive for arbitrage.
Two Point Arbitrage
Two Point Arbitrage
Q1| The Reuters' Monitor shows the following

information about the exchange rate between
the Australian dollar and the US dollar
(measured in direct quotation in both centres):
• Sydney 1.7800 (USD /AUD)
• New York 0.5747 (AUD /USD)
To find out whether or not there is an arbitrage
opportunity, we have to check whether the no-
arbitrage condition is violated.
Two Point Arbitrage
The Reuters' Monitor shows the following information about the exchange rate between
the Australian dollar and the US dollar (measured in direct quotation in both centres):
• Sydney 1.7800 (USD/AUD)
• New York 0.5747 (AUD/USD)
To find out whether or not there is an arbitrage opportunity, we have to check whether
the no-arbitrage condition is violated.
Solution:
• When we invert the exchange rate in New York, we
obtain 1/0.5747=1.7400.
• Thus, the no-arbitrage condition is violated in the
sense that the USD is more expensive in Sydney than
in New York.
• Hence, arbitragers buy the US currency in New York at
1.7400 and sell it in Sydney at 1.7800.
• Profit in Australian dollar per US dollar bought and
sold is = 1.7800 — 1.7400 = 0.0400 or 400 points.
Two Point Arbitrage
Solution:
• The effect of arbitrage is to raise the price of the USD in New York
and lower it in Sydney, until they are equal somewhere between
1.7800 and 1.7400. Suppose that at some stage prior to the
restoration of equilibrium, changes in supply and demand cause the
exchange rate to fall to 1.7700 in Sydney and rise to 1.7500 (or
0.5714 in direct quotation) in New York.
• In this case, profit shrinks to 1.7700 — 1.7500 = 0.0200 or 200

points.
• Eventually, the rate falls to 1.7600 in Sydney and rises to the same
level (0.5682 in direct quotation) in New York.
• Profit at this stage is = 1.7600 — 1.7600 = 0
• which means that arbitrage is not profitable because the no-

arbitrage condition is restored.
Two Point Arbitrage
Two-point
arbitrage with
the bid-offer
spread
• So far, we have seen how arbitrage works by

assuming that there is no bid—offer spread. If
this assumption is relaxed, the no-arbitrage
condition in this case is given by the equations
Sb , A ( x / y ) = S a , B ( x / y )
S a , A ( x / y ) = Sb , B ( x / y )
Where Sb,A(x/y) is the bid rate in A, and so on.
Two Point Arbitrage
Two-point arbitrage with the bid-offer spread
• Let us now see what happens if the

equilibrium condition is violated, such
that Sb,A (x/y) > Sa,B(xly).
• In this case the arbitrager can make profit
by buying y in B at Sa,B(x/y) and selling it in
A for S b,A (xly).
• Arbitrage profit is the difference between
the selling rate and the buying rate, or
Sb,A(x/y) - Sa,B(xly).
Two Point Arbitrage
Q2| The exchange rate between the

pound and Australian dollar (AUD/
GBP) as recorded in Sydney and
London is as follows:
• Sydney 0.3750 - 0.3790
• London 0.3700 - 0.3740
Two Point Arbitrage
The exchange rate between the pound and
Australian dollar (AUD/GBP) as recorded in Sydney
Solution: and London is as follows:
• Sydney 0.3750 - 0.3790
• London 0.3700 - 0.3740
Two Point Arbitrage
The exchange rate between the pound and
Australian dollar (GBP/AUD) as recorded in Sydney
and London is as follows:
• Sydney 0.3750 - 0.3790
Solution: • London 0.3700 - 0.3740
• If arbitrage is possible at the mid-rates, then we have

the following:
 Sydney 0.3770
 London 0.3720
• The arbitrager in this case buys the Australian dollar in

London at GBP0.3720 and sells it in Sydney at
GBP0.3370.
• Arbitrage profit in this case is 0.005 or 50 points.

Two Point Arbitrage
Q3| Given :
• Bank A quotes USD/INR 40.2350 - 40.2400
• Bank B quotes USD/INR 40.2425 - 40.2475
Identify and calculate arbitrage gain.
Two Point Arbitrage
Given :
Bank A quotes USD/INR 40.2350 - 40.2400
Bank B quotes USD/INR 40.2425 - 40.2475
Solution:
• The Bid price of Bank B is more than the Ask
price of Bank
• A which means that Bank A is selling USD at a
rate lower than the buying rate of Bank B.
• The arbitrageur would exploit this, imperfection
by buying USD from Bank A and selling the same
to Bank B.
Two Point Arbitrage
Given :
Solution:
Arbitrage calculations, therefore, involve two
steps:
1) Identifying the rates between which arbitrage is
possible and
2) Quantifying the arbitrage gain on an assumed
or given the amount of capital.
• Bid 40.2425 > Ask 40.2400
• Therefore arbitrage exists.
Two Point Arbitrage
For a person to get arbitrage gain it is necessary for

him to analyze the quotations given, if the bid rate of 1
quotation is greater than the ask rate of another
quotation then, he can earn on arbitrage gain.
Where, P = Principle amount

B = Identified Bid rate
A = Identified Ask rate.
Two Point Arbitrage
Given :
Solution:
• Assume capital USD 1 million
• Arbitrage gain = (Principal x Identified Bid rate) / Identified
Ask rate - Principal
• (1,000,000 x 40.2425) / 40.2400 — (1,000,000)
• USD 62.13 per USD 1 million.
• Note: Assumption of capital can be in either of the two
currencies.
• In case the assumed capital was INR then the resultant
gain/profit would be in INR.
Two Point Arbitrage
Given :
Solution:
• Derivation of Formula for calculating arbitrage:
• In the above example, the arbitrageur would first sell USD 1,000,000
to Bank B @ 40.2425 and acquire equivalent INR = 1,000,000 x
40.2400.
• He would simultaneously sell these INR to Bank A @ 40.2400 and
reconvert to (1,000,000 x 40.2425)/40.2400 USD =Since the
multiplier is more than the divisor, the arbitrageur would now have
more than USD 1,000,000. The balance left with him after
withdrawing the capital used would reflect the gain made in the (1,
000, 000 x 44,2425) transaction. Therefore gain = 40.2400 (1, 000,
000) ,
Two Point Arbitrage
Q4| The following 2 quotations are given.

Bank A = USD /INR = 44.7130 - 44.7150
Bank B = USD /INR = 44.7250 - 44.7300
Identify whether arbitrage is possible and if
so calculate the gain on an investment of 1
million US $
Two Point Arbitrage
The following 2 quotations are given.
Bank A = USD /INR = 44.7130 - 44.7150
Bank B = USD /INR = 44.7250 - 44.7300
Identify whether arbitrage is possible and if so calculate the gain on an investment of 1
million US $
Solution:
Bank A = USD /INR = 44.7130 - 44.7150

Bank B = USD /INR = 44.7250 - 44.7300
 Arbitrage is possible because bid rate of Bank B is greater than
the Ask rate of Bank A.
 Therefore, Arbitrage gain = ( 1,000,000 * 44.7250/ 44.7150) -
1,000,000
 Arbitrage gain = 223.6386
 Therefore, Arbitrage gain is US $ = 223.6386/ US $ 1 million.
Two Point Arbitrage
Q5| Given SGD/GBP = 2.7118 – 2.7128

Given SGD/GBP = 2.7188 – 2.7198
Is arbitrage possible, calculate arbitrage
gain, if any. Where, P= £ 1 million.
Two Point Arbitrage
Given SGD/GBP = 2.7118 – 2.7128
Given SGD/GBP = 2.7188 – 2.7198
Is arbitrage possible, calculate arbitrage gain, if any. P= £ 1 million.
Solution:
SGD/GBP = 2.7118 – 2.7128

SGD/GBP = 2.7188 – 2.7198
Arbitrage is possible because bid rate of second quote is greater
than the Ask rate of first quote.
Therefore, Arbitrage gain = ( 1,000,000 * 2.7188 / 2.7128) -

1,000,000
Arbitrage gain = 2211.7369
Therefore, Arbitrage gain is £ = 2211.7369/ £ 1 million.

Two Point Arbitrage
Q6| Determine whether arbitrage is

possible and calculate the arbitrage gain
for 10,000,000 units of currency.
a. Euro/USD = 5.0112Two - 5.0132
USD/Euro = 0.1972 – 0.1982
b. SEK / GBP = 11.1118 – 11.1168

GBP / SEK = 0.0918 - 0.0948
Two Point Arbitrage
Solution:
a. Euro/USD = 5.0112 - 5.0132

USD/Euro = 0.1972 – 0.1982
 (Euro/USD)Bid = 1/(USD/Euro)Ask
= 1/ 0.1982
= 5.0454
 (Euro/USD) Ask = 1/(USD/Euro) Bid
= 1/ 0.1972
= 5.0710
 (Euro/USD) = 5.0454 - 5.0710
Two Point Arbitrage
Solution:
a. Euro/USD = 5.0112 - 5.0132

USD/Euro = 0.1972 – 0.1982
 (Euro/USD) = 5.0454 - 5.0710
 Arbitrage is possible because the bid of second
rate of Euro/USD is greater than first rate of
Euro/USD.
 Arbitrage = (10,000,000* 5.0454/ 5.0132) -
10,000,000
 Arbitrage = 64230.4316
 Arbitrage gain is US $ = 64230.4316/ US $ 10
million.
Two Point Arbitrage
Solution:
b. SEK / GBP = 11.1118 – 11.1168

GBP / SEK = 0.0918 - 0.0948
 (SEK / GBP)Bid = 1/(GBP/ SEK )Ask
= 1/ 0.0948
= 10.5485
 (SEK / GBP ) Ask = 1/(GBP / SEK ) Bid
= 1/ 0.0918
= 10.8932
 (SEK / GBP) = 10.5485 - 10.8932
Two Point Arbitrage
Solution:
b. SEK / GBP = 11.1118 – 11.1168

(SEK / GBP) = 10.5485 - 10.8932
 Arbitrage is possible because the bid of first rate of
Two
SEK / GBP is greater than second rate of SEK / GBP.
 Arbitrage = (10,000,000* 11.1118/ 10.8932) -
10,000,000
 Arbitrage = 200675.6508
 Arbitrage gain is £ = 200675.6508 / £ 10 million.
Two Point Arbitrage
Q7| Given:
Bank A USD/INR 40.1625 - 40.1665
Bank B USD/INR 40.1695 - 40.1735
Identify and calculate
Two arbitrage gain if
both quotations are valid for USD 1
million only.
Two Point Arbitrage
Given:
Bank A USD/INR 40.1625 - 40.1665
Bank B USD/INR 40.1695 - 40.1735
Identify and calculate arbitrage gain if both quotations are valid for
USD 1 million only.
Solution:
Two
In real market conditions quotations are valid for specific
base currency amounts. When this fact has specified the
formula to be used for calculating the gain is:
Arbitrage gain = (principal x identified bid) - (principal x
identified ask)
• Bid 40.1695 > Ask 40 1665
• Therefore arbitrage exists.
Two Point Arbitrage
Given:
Bank A USD/INR 40.1625 - 40.1665
Bank B USD/INR 40.1695 - 40.1735
Identify and calculate arbitrage gain if both quotations are valid for USD 1 million only.
Solution:
Assume capital USD 1 million since both quotations are

valid for this amount. Two
Arbitrage gain = (principal x identified bid) - (principal

x identified ask)
Arbitrage gain = (1,000,000 x 40.1695) - (1,000,000 x
40.1665)
= INR 3000 per USD 1 million.
Note: The gain is computed in variable currency
whereas capital assumed is in base currency.
Two Point Arbitrage
Capital Gain Formula
Base currency Base currency
Variable
Base currency (Principal x Bid) - (Principal x Ask)
currency Two
Variable Variable
currency currency
Variable
Base currency
currency
Three Point Arbitrage or Triangular Arbitrage
Two
Two steps are involved in three-point arbitrage:
I. Checking whether or not the
condition is violated (that is, whether
or not the cross rates are consistent);
and Two
II.determining the profitable sequence.
Let us assume that the no-arbitrage condition is

violated such that:
S(x/y) > S(x/z)/S(y/z)
 The profitable sequence can be determined with the
aid of a triangle, placing each one of the three
currencies in one of its corners (in no special order), as
shown in figure.
 Determination of the profitable sequence is simple. We
start with one unit of any of the three currencies and
Two
move clockwise as in Figure (a) around the triangle
until we end up where we started from, with the same
currency.
 In this case, we end up with less than one unit of the
currency we started with, which gives the unprofitable
sequence.
 The profitable sequence will be in an anti-clockwise
direction, as in figure (b).
Profitable and unprofitable sequences in three-point arbitrage
Two
By starting with one unit of currency x and
moving clockwise, as in Figure (a), arbitrage
involves the following steps:
1.Selling x and buying y to obtain 1/S(x/y)
units of y.
2.Selling y and buying z to obtain 1/(S(x/y)
S(y/z)] units ofTwo
z.
3.Selling z and buying x to obtain
S(x/z)/[S(x/y) S(y/z)] units of x.
• Since S(x/y) > S(x/z)/S(y/z),

• It follows that S(x/z)/S(y/z) < S(x/y) or that S(x/z)/ [S (x/y) S (y/z)] < 1.
• Hence, we end up with less than one unit of x. The profitable sequence
must, therefore, be in a counter-clockwise direction.
This sequence, as represented by Figure (b),
involves the following steps:
• Selling x and buying z to obtain 1/S(x/z)

units of z.
• Selling z and Two buying y to obtain
S(y/z)/S(x/z) units of y.
• Selling y and buying x to obtain S(y/z)
S(x/y)/S(x/z) units of x.
• Since S(x/y) > S(x/z)/S(y/z),

• It follows that S(y/z)S(x/y)/S(x/z)> 1.
• Thus, we end up with more than one unit of x, and this must be the
profitable sequence.
The possibilities for three-point arbitrage can be
summarized as follows:
• If S(x/y) = S(x/z)/S(y/z), then there is no
arbitrage opportunity.
Two
• If S(x/y) > S(x/z)/S(y/z), then there is a
profitable arbitrage opportunity by following
the sequence x → z →y →x.
• If S(x/y) < S(x/z)/S(y/z), then there is a

profitable arbitrage opportunity by following
the sequence x → y → z →x.
Arbitrage restores the equilibrium condition via changes in
the supply of, and demand for, currencies. Let us trace what
happens when S(x/y) > S(x/z)/S(y/z). Figure in next slide
shows that the buying and selling of currencies result in
changes in the forces of supply and demand, as follows:
1. An increase in the demand

Two for z (the supply of x),
and so S(x/z) rises as shown in Figure (a).
2. An increase in the demand for y (the supply of z),

and so S(y/z) falls as shown in Figure (b).
3. An increase in the demand for x (the supply of y),

and so S(x/y) falls as shown in Figure (c).
The effect of three-point arbitrage
Two
Q1| The following exchange rates are quoted in Sydney,

Auckland, and Hong Kong:
S(AUD/HKD) 4.1548
S(AUD/NZD) 1.2052
S(NZD/HKD) 3.5825 Two
The following exchange rates are quoted in Sydney, Auckland,
and Hong Kong:
S(AUD/HKD) 4.1548
S(AUD/NZD) 1.2052
S(NZD/HKD) 3.5825
• To find out whether orTwonot there is a possibility for
three-point arbitrage, we have to check the
consistency of the cross rates (the validity of the no-
arbitrage condition).
• S(NZD/HKD) can be calculated from the other two
rates as
• S(NZD/HKD) = S(AUD/HKD) / S(AUD/NZD)
• = 4.1548/1.2052 = 3.4474
The following exchange rates are quoted in Sydney, Auckland, and Hong Kong:
S(AUD/HKD) 4.1548
S(AUD/NZD) 1.2052
S(NZD/HKD) 3.5825
• Hence, the equilibrium condition is violated, implying

a possibility for three-point arbitrage.
• First, try the sequence Two
HKD → NZD → AUD → HKD,
starting with one unit of HKD:
1)Sell HKD 1.0000 for NZD to obtain (1/3.5825 =
0.2791) units of NZD.
2)Sell NZD 0.2791 for AUD to obtain (0.2791/1.2052 =
0.2316) units of AUD.
3)Sell AUD 0.2316 for HKD to obtain (0.2316 x 4.1548 =
0.9623) units of HKD.
• Obviously, this is not the profitable sequence.
S(AUD/HKD) 4.1548
S(AUD/NZD) 1.2052
S(NZD/HKD) 3.5825
• Now, try the opposite sequence, starting with one unit of

HKD:
Two
1) Sell HKD 1.0000 for AUD to obtain (1/4.1548 = 0.2407)
units of AUD.
2) Sell AUD 0.2407 for NZD to obtain (0.2407 x 1.2052 =
0.2901) units of NZD.
3) Sell NZD 0.2901 for HKD to obtain (0.2901 x 35825 =
1.0392) units of HKD.
• This is obviously the profitable sequence.
S(AUD/HKD) 4.1548
S(AUD/NZD) 1.2052
S(NZD/HKD) 3.5825
• If S(NZD/HKD) = 3.4474, then there is no possibility for

three-point arbitrage because this rate is consistent with
the others. At this stage we have:
Two
S(AUD/HKD) / S(NZD/HKD)S(AUD/NZD)
= 4.1548/3.4474 x 1.2052 = 1.0000
and
S(AUD/NZD)S(NZD/HKD) / S(AUD/HKD)
= 1.2052 x 3.4474/ 4.1548 =1.0000
• Which shows that there is no profitable sequence.

Q2| Given INR/USD = 44.3450 - 44.3500

CHF/ USD = 1.3775 – 1.3785
INR / CHF = 32.1625 – 32.1650
Identify and calculate
Two
arbitrage on 5
million units of a currency.
Given INR/USD = 44.3450 - 44.3500
CHF/ USD = 1.3775 – 1.3785
INR / CHF = 32.1625 – 32.1650
Identify and calculate arbitrage on 5 million units of a currency.
Solution:
(INR / USD)Bid = (INR / CHF )Bid * (CHF / USD)Bid

= 32.1625 * 1.3775Two
= 44.3038
(INR / USD)Ask = (INR / CHF )Ask * (CHF / USD)Ask
= 32.1650 * 1.3785
= 44.3394 Arbitrage is possible because bid
(INR / USD) = 44.3038 - 44.3394 rate of first rate is > ask rate of
second rate.
Compare;
That is, bid rate = 44.3450 > ask
1. INR/USD = 44.3450 - 44.3500 rate = 44.3394
2. (INR / USD) = 44.3038 - 44.3394
Given INR/USD = 44.3450 - 44.3500.
CHF/ USD = 1.3775 – 1.3785
INR / CHF = 32.1625 – 32.1650
Solution:
Arbitrage gain = ( 5,000,000 *Two

44.3450/ 44.3394) - 5,000,000
Arbitrage gain is US $ 620.2145/US$ 5 million.
Q3| Given Euro / GBP = 1.4905 – 1.4920.

USD/Euro = 1.3005 -1.3020
GBP/ USD = 0.5105 – 0.5120
Identify and calculateTwoarbitrage on 1 million
units of a currency.
Given Euro / GBP = 1.4905 – 1.4920.
USD/Euro = 1.3005 -1.3020
GBP/ USD = 0.5105 – 0.5120
Solution:
(Euro / GBP )Bid = (Euro/ USD)Bid * (USD/GBP)Bid

= 1/ 1.3020 * 1/ 0.5120
= 0.7680*1.9531 Two
= 1.5001
(Euro / GBP )Ask = (Euro/ USD)Ask * (USD/GBP)Ask
= 1/1.3005 * 1/ 0.5105
= 0.7689*1.9589 Arbitrage is possible because
= 1.5062 bid rate of second rate is > ask
(Euro / GBP ) = 1.5001 - 1.5062 rate of first rate.
Compare; That is, bid rate = 1.5001 > ask
1. Euro / GBP = 1.4905 – 1.4920 rate = 1.4920
2. (Euro / GBP ) = 1.5001 - 1.5062
Given Euro / GBP = 1.4905 – 1.4920.
USD/Euro = 1.3005 -1.3020
GBP/ USD = 0.5105 – 0.5120
Solution:
1.5001 / 1.4920) - 1,000,000

Arbitrage gain = ( 1,000,000 *Two
Arbitrage gain is £ 5428.9544/ £ 1 million.
Q4| A bank in Mumbai offers to sell

USD against INR at USD/INR 44.3800
whereas a bank in the US offers to sell
INR against USDTwo at 100 INR/USD
2.2535. Would you undertake the
transactions?
A bank in Mumbai offers to sell USD against INR at USD/INR
44.3800 whereas a bank in the US offers to sell INR against USD
at 100 INR/USD 2.2535. Would you undertake the
transactions?
Solution:
• Note: When comparing rates, the base currency should be

identical.
Two
• As per given data :
• We can buy USD @ INR 44.3800
• We can sell USD @ INR 100 x 1 / 2.2535 = 44.3754
• By undertaking the transaction we would incur a loss since our

buying the rate for USD would be higher than our selling rate for
USD.
Q5| Following quotes are provided by

three different traders :
• Trader A: 1.6818 - 28 USD per GBP
• Trader B: 6.0025Two- 25 SEK per USD
• Trader C: 10.0800 - 00 SEK per GBP
Establish if an opportunity for
arbitrage exists and if yes, calculate
the profit on capital USD 1 million;
using synthetic mechanism.
Following quotes are provided by three different traders :
• Trader B: 6.0025 - 25 SEK per USD
Establish if an opportunity for arbitrage exists and if yes, calculate the profit on
capital USD 1 million; using synthetic mechanism.
Solution:
Two
Note : (1) When currency of capital is specified that
currency cannot be eliminated when deriving the
quotation comparable to the third quotation.
(2) The establishing of arbitrage opportunity by
converting 3-currency comparison into a 2-currency
comparison is called "Synthetic Mechanism” and the
derived Quotation is called the "Synthetic Quote".
Establish if an opportunity for arbitrage exists and if yes, calculate the profit on capital
USD 1 million; using synthetic mechanism.
Solution:
Reconstructing the given

Two
quotations as per ACI
convention, we get :
• GBP / USD 1.6818 - 1.6828 ...(1)
• USD / SEK 6.0025 - 6.0125 ...(2)
• GBP / SEK 10.0800 - 10.0900 —(3)
Using quotations (1) & (3) we can derive USD/SEK
quotation comparable to quotation (2)
Solution:
Two
Derived :
(USD/SEK)Bid = (USD/GBP)Bid * (GBP/SEK)Bid ...Chain Rule
= 1/ (GBP/USD)Ask * (GBP/SEK)Bid ...Inverse Rule
= 1 * 10.0800 / 1.6828 = 5.9900

Establish if an opportunity for arbitrage exists and if yes, calculate the profit on capital USD 1 million;
using synthetic mechanism.
Solution:
(USD/SEK)Ask = (USD/GBP) Ask

Twox (GBP/SEK)
Ask ...Chain Rule
=1 / (GBP/USD)Bid x (GBP/SEK)Ask ...Inverse Rule
=1 x 10.0900 / 1.6818
= 5.9995
Solution:
• Derived USD/SEK 5.9900 — 5.9995

• Given USD/SEK 6.0025 — 6.0125
Two
• BID 6.0025 > ASK 5.9995
• Arbitrage exists
• Assume capital USD 1 million ... (given)

Establish if an opportunity for arbitrage exists and if yes, calculate the profit on
Solution: capital USD 1 million; using synthetic mechanism.
Profit = [1, 000, 000 x 6.0025/5.9995]

Two
- 1,000,000
= [1, 000, 000 x 6.0025x 1.68181/10.0900] - 1,000,000
= 496
Profit on capital of USD 1 million = USD 496

Q6| Assuming zero transaction cost,

calculate arbitrage that can be derived
from the following quotes:
• 1 GBP = USD 1.6508 – 18
• 1 USD = AUD 1.1783 – 93
• 1 GBP = AUD 1.9420 - 30
Assuming zero transaction cost, calculate arbitrage that can be
derived from the following quotes:
• 1 GBP = USD 1.6508 – 18
• 1 USD = AUD 1.1783 – 93
• 1 GBP = AUD 1.9420 – 30. Capital GBP 1 million.
Solution:
Reconstructing quotations as per ACI

convention, we get:
GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
GBP/AUD 1.9420 – 1.9430 → Given
Reconstructing quotations as per ACI convention, we get:
GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
GBP/AUD 1.9420 – 1.9430 → Given. Capital GBP 1 million.
Solution:
Derived - GBP/ AUD = (GBP/USD)Bid * (USD/AUD)Bid
= 1.6508 * 1.1783
=1.9451
Reconstructing quotations as per ACI convention, we
get:
GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
GBP/AUD 1.9420 – 1.9430 → Given
Solution:
Derived - GBP/ AUD = (GBP/USD)Ask * (USD/AUD)Ask
= 1.6518 * 1.1793
=1.9480

GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
Solution:
Derived → GBP/ AUD 1.9451 - 1.9480

Given → GBP/AUD 1.9420 – 1.9430
GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
Solution:
Derived → GBP/ AUD 1.9451 - 1.9480

Given → GBP/AUD 1.9420 – 1.9430
Therefore, BID 1.9451 > ASK 1.9430
Arbitrage exists
GBP/USD 1.6508 – 1.6518
USD/AUD 1.1783 – 1.1793
Solution:
Arbitrage = [ 1,000,000 * 1.9451/1.9430] - 1,000,000
= [ 1,000,000 * 1.6508*1.1783/1.9430] - 1,000,000

= GBP 1100 per GBP 1 million.
Q7| Following quotations are available

at a given time:
• Bank A: 1.3995 – 05 SGD per USD
• Bank B: 31.5350 – 00 INR per SGD
• Bank C: 2.2628 – 33 USD per 100 INR
Capital USD 1 million.
Following quotations are available at a given time:
• Bank A:1.3995 – 05 SGD per USD
• Bank B: 31.5350 – 00 INR per SGD
• Bank C:2.2628 – 33 USD per 100 INR
Identify and calculate arbitrage gain for USD/SGD.
Solution:
Two
Reconstructing the quotations as per ACI convention, we
get….
• USD/SGD 1.3995 – 1.4005
• SGD/INR 31.5350 – 31.5400
• 100 INR/USD 2.2628 – 2.2633

 INR/USD 0.022628 - 0.022633
Step 1: Reconstructing the quotations as per ACI convention, we get….
• USD/SGD 1.3995 – 1.4005
• SGD/INR 31.5350 – 31.5400
• 100 INR/USD 2.2628 – 2.2633
 INR/USD 0.022628 - 0.022633
Solution:
Two
(USD/SGD)Bid = (USD/INR)Bid * (INR/SGD)Bid
=1/(INR/USD)Ask * 1/(SGD/INR) Ask
= 1/ 0.022633 * 1/31.5400
= 1.4009
USD/SGD 1.3995 – 1.4005
SGD/INR 31.5350 – 31.5400
100 INR/USD 2.2628 – 2.2633
= INR/USD 0.022628 - 0.022633
Solution:
(USD/SGD)Ask = (USD/INR)
Two
Ask * (INR/SGD)Ask
=1/(INR/USD)Bid * 1/(SGD/INR)Bid
= 1/ 0.022628 * 1/31.5350
= 1.4014
USD/SGD 1.3995 – 1.4005
SGD/INR 31.5350 – 31.5400
100 INR/USD 2.2628 – 2.2633
= INR/USD 0.022628 - 0.022633. Principal amount 1 million USD.
Solution:
Two
• Derived (USD/SGD) = 1.4009 - 1.4014

• Given USD/SGD = 1.3995 – 1.4005
• Therefore Bid 1.4009 > Ask 1.4005

• Arbitrage Exists
Step 1
Reconstructing the quotations as per ACI convention, we get….
USD/SGD 1.3995 – 1.4005
SGD/INR 31.5350 – 31.5400
100 INR/USD 2.2628 – 2.2633
= INR/USD 0.022628 - 0.022633
Solution:
Two
Assume capital USD 1 million

=[1000000*1.4009/1.4005] - 1000000
=[1000000 / 1.4005 * 1/ 0.022633 *
1/31.5400] – 1000000
= USD 260 PER USD 1 MILLION
Q8| Bank in Mumbai quotes USD/INR

44.6300 – 50 whereas Bank us USA quotes
100 INR/USD 2.2410 – 15. Identify if any
advantage can be Twoderived from these
quotes:
Bank in Mumbai quotes USD/INR 44.6300 – 50 whereas Bank us
USA quotes 100 INR/USD 2.2410 – 15. Identify if any advantage
can be derived from these quotes:
Solution:
1) USD/INR 44.6300 – 44.6350 Two
2) 100 INR/USD 2.2410 – 2.2415

• Quotation (2) can be inversed to
make it comparable to
quotation(1).
Solution:
Two
(USD/INR)Bid = 1/(INR/USD)Ask
(USD/INR)Bid = 1*100/(100 INR/USD)Ask
(USD/INR)Bid = 1*100/2.2415
(USD/INR)Bid = 44.6130
Solution:
Two
(USD/INR) Ask = 1/(INR/USD)Bid
(USD/INR)Ask = 1*100/(100 INR/USD)Bid
(USD/INR)Ask = 1*100/2.2410
(USD/INR)Ask = 44.6229
Solution:
Two
• Derived USD/INR 44.6130 - 44.6229
• Given USD/INR 44.6300 - 44.6350
Therefore, Bid 44.6300 > Ask 44.6229
Arbitrage exists
Solution:
Two
Arbitrage = [1,000,000* 44.6300/44.6229] - 1,000,000
Arbitrage = [1,000,000* 44.6300*2.2410/100] -
1,000,000
Arbitrage = USD 158 per USD 1 million.

Cross Currency Rate
Rule
• While arriving at cross rates two possibilities exist.

• The base currencies for the two currency pairs are different.
• Base currency is define by the adoption of foreign payment and
receipt in terms of particular foreign currency.
• Hence USD will be base currency irrespective of direct or indirect
quote.
• And for GBP,EURO,AUD and NZD are base currencies in case of USD.
• For example, if we want to calculate the rate for INR/GBP; two
currency pairs involved are INR/USD and USD/GBP.
• In first currency pair, base currency is USD while in the second the
base currency is GBP. Since the base currencies are different the
cross rates can be calculated by multiplying bid rate of one currency
pair by that of another one.
• Thus INR/GBPbid = INR/USDbid multiplied by USD/GBPbid.
• Same works out for ask rates.
Cross Currency Rate
Rule
• While arriving at cross rates two possibilities exist.

• The base currency for the two currency pairs is the
same.
• For example, an INR/JPY quote can be worked out by
using INR/USD and JPY/USD quotes. Since in both
these pairs, USD is the base currency the cross
currency calculation requires dividing bid rate of one
currency pair by ask rate of another and dividing ask
rate for one currency pair by bid rate of another.
• Thus INR/JPYbid = INR/USDbid divided by JPY/USDask.
• INR/JPYask = INR/USDaskdivided by JPY/USDbid.

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International

Arbitrage Part I ITM BUSINESS SCHOOL

• The price difference is possible only if there is an

• An arbitrageur(a person who does arbitrage) is an

entity who identifies an opportunity for arbitrage

and initiates transactions so as to benefit from

• Sudden imbalance in the demand & supply

• Two point arbitrage: 2 - point arbitrage is also called as

Also known as spatial arbitrage or

• Given two financial centres, A and B, and two currencies,

Two-point arbitrage without the bid—offer spread

• The arbitrage process restores equilibrium via changes in

Q1| The Reuters' Monitor shows the following

• In this case, profit shrinks to 1.7700 — 1.7500 = 0.0200 or 200

• Profit at this stage is = 1.7600 — 1.7600 = 0

• which means that arbitrage is not profitable because the no-

• So far, we have seen how arbitrage works by

Two-point arbitrage with the bid-offer spread

• Let us now see what happens if the

Q2| The exchange rate between the

• If arbitrage is possible at the mid-rates, then we have

• The arbitrager in this case buys the Australian dollar in

• Arbitrage profit in this case is 0.005 or 50 points.

For a person to get arbitrage gain it is necessary for

Where, P = Principle amount

Q4| The following 2 quotations are given.

Bank A = USD /INR = 44.7130 - 44.7150

Q5| Given SGD/GBP = 2.7118 – 2.7128

SGD/GBP = 2.7118 – 2.7128

Therefore, Arbitrage gain = ( 1,000,000 * 2.7188 / 2.7128) -

Therefore, Arbitrage gain is £ = 2211.7369/ £ 1 million.

Q6| Determine whether arbitrage is

USD/Euro = 0.1972 – 0.1982

b. SEK / GBP = 11.1118 – 11.1168

a. Euro/USD = 5.0112 - 5.0132

a. Euro/USD = 5.0112 - 5.0132

b. SEK / GBP = 11.1118 – 11.1168

b. SEK / GBP = 11.1118 – 11.1168

Assume capital USD 1 million since both quotations are

Arbitrage gain = (principal x identified bid) - (principal

Base currency Base currency

II.determining the profitable sequence.

Let us assume that the no-arbitrage condition is

• Since S(x/y) > S(x/z)/S(y/z),

• Selling x and buying z to obtain 1/S(x/z)

• Since S(x/y) > S(x/z)/S(y/z),

• If S(x/y) < S(x/z)/S(y/z), then there is a

1. An increase in the demand

2. An increase in the demand for y (the supply of z),

3. An increase in the demand for x (the supply of y),

Q1| The following exchange rates are quoted in Sydney,

• Hence, the equilibrium condition is violated, implying

• Now, try the opposite sequence, starting with one unit of

• If S(NZD/HKD) = 3.4474, then there is no possibility for

• Which shows that there is no profitable sequence.

Q2| Given INR/USD = 44.3450 - 44.3500

(INR / USD)Bid = (INR / CHF )Bid * (CHF / USD)Bid

Arbitrage gain = ( 5,000,000 *Two

Q3| Given Euro / GBP = 1.4905 – 1.4920.

(Euro / GBP )Bid = (Euro/ USD)Bid * (USD/GBP)Bid

1.5001 / 1.4920) - 1,000,000

Q4| A bank in Mumbai offers to sell

• Note: When comparing rates, the base currency should be