Suppose that you observe the following exchange rates:?

Question

Suppose that you observe the following exchange rates:
$2/￡, $.0075/￥, ￡.005/￥.

Is there cross-rate equality ? If yes, why? If not , what would you expect happen?

Answer 1

Best Answer - Chosen by Voters

There is no cross rate equality.

At $2 per ￡; at equality, the rate per ￥ would be $.01 instead of the noted rate of $.0075.

What you would expect to happen in this circumstance is something called Arbitrage.

Arbitrage is defined as: the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

In this case someone could take $1,000, exchange it for ($1,000 / .0075) 133,333 ￥, and then exchange the 133,333.33 ￥, into ￡666.66. Those ￡666.66 could then be re-exchanged into $1,333.33, thus earning the Arbitrageur a quick 33.33% profit.

Source(s):

35 years of accounting and finance experience