As a result of this class, you have become an experienced and avid international

Question

As a result of this class, you have become an experienced and avid international investor. On the Paris Stock Exchange, Air France-KLM stock closed at EUR11.20 per share on Friday, April 11, 2014. Air France-KLM also trades as an ADR on the NYSE. One underlying Air France-KLM share equals one Air France-KLM ADR. On April 11, 2014, the USD/EUR spot exchange rate was $1.3912/EUR1.

a. At this exchange rate, what is the no-arbitrage U.S. dollar price of one Air France-KLM ADR?

b. By comparison, Air France-KLM ADRs traded at $15.44 on April 11, 2014. Do you think an arbitrage opportunity existed?

Why or why not?

Explanation / Answer

Considering spote exchange rate of USD/EUR = US$ 1.3912/EUR 1, as on April 11, 2014.

(a) The no-arbitrage U.S. dollar price of one Air France-KLM ADR :

= (US$ 1.3912/EUR 1) x EUR 11.20 = US$15.58

(b) If Air France-KLM ADRs traded at $15.44, it's market price on Paris Stock Exchange should be as follows on April 11, 2014:

= (EUR 1/US$1.3912) x US$15.44 = EUR11.10

Calculated price is EUR11.10 whereas price on Paris SE is EUR 11.20, as such there is an arbitrage opportunity existed.

The investor can buy it on NYSE at US$15.44, convert it into share. As such the investor can have sahre at effective price of EUR11.10, which can be sold on Paris SE at EUR11.20 per share. This will result into a benefit of EUR 0.10 per share.

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