There are three foreign exchange markets: Market 1: ¥1=$0.01 Market 2: MYR 1= $0

Question

There are three foreign exchange markets:

Market 1: ¥1=$0.01

Market 2: MYR 1= $0.2

Market 3: MYR 1= ¥25

Note: ¥ is the Japanese Yen.

MYR is the Malaysian Ringgit.

$ is the U.S. dollar.

a. Suppose you hold Japanese Yen, Malaysian Ringgit, and dollars. Is it possible for you to do arbitrage in the above three markets? If yes, how would you engage in arbitrage to profit from these three rates? What is your profit?

b. Is there any pressure on the cross-rate between the Yen and the MYR? What must the value of the cross-rate between the Yen and the MYR be to eliminate the opportunity for triangular arbitrage?

Explanation / Answer

Market 1: ¥1=$0.01

Market 2: MYR 1= $0.2

Market 3: MYR 1= ¥25

Yes, arbitrage is possible. Suppose I exchange my MYR 1 is market 3 and get ¥25. Now, If I go to market 1, ¥25 will be excahnged and yield me $0.25, which is greater than what I would have got in market 2 for 1 MYR.

Profit = $0.05

b. There is pressure on the cross-rate between the Yen and the MYR.

MYR 1 should be equal to ¥20

Hence, this should be the value of the cross-rate between the Yen and the MYR to eliminate the opportunity for triangular arbitrage.

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