Reading 12, currency exchange

CFA Level II Economics
#1

CFA L2 curriculum, page 484 - 485

Question 4 from page 484.

Implied JPY/CAD interbank rate: 85,76 bid ; 85,80 ask Dealer offered JPY/CAD rate: 85,74 bid ; 85,81 ask

Why is answere C incorrect? “Its possible to make arbitrage profits buying CAD from the dealer and selling it in the interbank market” ? The correct answere given is that no arbitrage profits are possible.

Why can we not buy CAD from the dealer (using JPY @ 85,74 “down-the-bid”) and sell in the interbank market CAD @ 85,80 “up-the-ask” ?

I would appreciate some help in understanding this seemingly simple topic.

Many thanks!

#2

It’s up the bid and multiply, down the ask and divide

#3

Yup, all clear now - thanks.

#4

I wrote an article on exchange rates (and triangular arbitrage) that may be of some help here: http://financialexamhelp123.com/triangular-arbitrage/.

The simple answer is that if you’re multiplying, you use the smaller number, and if you’re dividing, you use the larger number: either way, you end up with the _ smaller _ amount of the new currency.

#5

I’m sorry, I have already read Magician’s article and Schweser material, but I can’t get all this about “multiply” and “divide”: what and where?

Could you please clarify.

#6

Hi all, I’m having the same issue in understanding here. I think now I sort of undertsand triangular arbitrage when 3 currencies involved… But would someone who understands the above original question be kind enough to post there workings, hopefully if I see the workings I will finally be able to grasp the concept here… Please, please help

#7

Suppose that you have JPY1,000,000. You go to the dealer and buy CAD. How many CAD do you get?

JPY1,000,000 ÷ (JPY85.81/CAD1.0) = CAD11,653.65

You go to the interbank market and buy USD. How many USD do you get?

CAD11,653.65 ÷ (CAD0.9546/USD1.0) = USD12,207.89

You then buy JPY in the interbank market. How many JPY do you get?

USD12,207.89 × (JPY81.87/USD1.0) = JPY999,460.

No profit.

You should try the transactions the other way – start with JPY, buy USD in the interbank market, then buy CAD in the interbank market, then buy JPY from the dealer – and discover that you don’t get a profit that way, either.

#8

Cheers so much mate, this is absolute gold!!! I now see the forrest for the trees

#9

Hot dog!

Glad to hear it.

#10

Take a look at the transactions I wrote out three posts above.

In particular, note which exchange rate I used in each transaction:

  • In the first transaction, I divided by the larger (ask) rate, so that I got the smaller number of CAD
  • In the second transaction, I divided by the larger (ask) rate, so that I got the smaller number of USD
  • In the third transaction, I multiplied by the smaller (bid) rate, so that I got the smaller number of JPY

That’s the key: you decide to multiply depending on how the exchange rate is quoted (e.g., if the dealer had quoted CAD/JPY, then I would have multiplied, so that the JPY cancelled and I was left with CAD), and you decide on which rate to use by picking the one that gives you the _ smaller amount of the new currency _: multiply by the smaller number, or divide by the larger number.