I need some help on the following question, thanks.
e = euros
Suppose quotes for the dollar-euro exchange rate, E$/e, are as follows: in New York $1.50 per euro, and in
Tokyo $1.55 per euro. Describe how investors use arbitrage to take advantage of the difference in exchange
rates. Explain how this process will affect the dollar price of the euro in New York and Tokyo.
The price in NY is lower than Tokyo. An investor could buy euros in NY, wire the euros to Tokyo, then sell the euros in Tokyo, making a gross profit (before expenses) of $.05 per euro.
But such an arbitrager is increasing the demand for euros in NY and increasing the supply of euros in Tokyo. What should happen to the price of euros in each of these markets??
as demand increase in NY, price goes up, and as supply increase in Tokyo, price goes down, they eventually will equal?
Ta Da. Yes.
To understand how investors use arbitrage to take advantage of the difference in exchange rates, we first need to understand what arbitrage means in the context of currency exchange. Arbitrage refers to the practice of taking advantage of price differences in different markets to make a profit with little to no risk. In the case of currency exchange, investors can exploit the difference between exchange rates in different locations to profit from the discrepancies.
In this scenario, we have two exchange rates: $1.50 per euro in New York and $1.55 per euro in Tokyo. To take advantage of this discrepancy, investors can follow these steps:
1. In New York, an investor would buy euros with dollars at the rate of $1.50 per euro.
2. The investor would then travel to Tokyo with the euros.
3. In Tokyo, the investor would sell the euros for Japanese yen at the rate of $1.55 per euro.
4. Finally, the investor would convert the earned yen back to dollars.
By doing this, the investor would make a profit because they effectively bought euros cheaper in New York and sold them for a higher price in Tokyo.
The process of arbitrage affects the dollar price of the euro in both New York and Tokyo. When investors engage in this arbitrage activity, the demand for euros increases in New York and the supply of euros increases in Tokyo. Consequently, this increased demand in New York and increased supply in Tokyo would lead to an adjustment in exchange rates.
In New York, the increased demand for euros would cause the dollar price of the euro to rise. As more investors buy euros, the exchange rate in New York would increase closer to the rate in Tokyo. Conversely, in Tokyo, the increased supply of euros would cause the dollar price of the euro to decrease. The exchange rate in Tokyo would move closer to the rate in New York.
Overall, the process of arbitrage would create pressure on the exchange rates, pulling them closer together until the opportunity for arbitrage diminishes.