swaptiongamma, scratch that question. using the bid ask matrix and recognizing the base currencies are the same in the given exchange rates, we can calculate the implied cross rate… implied cross rate €/GBP= .4975 / .5008 given cross rate €/GBP= 0.3985 / 0.4 Schweser says therefore, the euro is overvalued, pound is undervalued. It takes too few euros to buy 1 pound, so we want our arbitrage trades to go in the direction that will cause us to sell overvalued euros for pounds at the ask rate of €0.4000. This determines the direction or the order of the currency conversions. (--\>euro --\> GBP ---\> ) My question is how did they compare the implied cross rate against the mkt rate to determine that the euro was overvalued?
Step 1 : Implied Cross Rate (is like the Intrinsic Value - what it should Ideally be) EURO/GBP = 0.4975(bid=buy):0.5008(ask=sell) Now this means that (Ideally) EURO/GBP = 0.4975 i.e. 1 GBP = 0.4975 EURO i.e 1 Pound buys 0.4975 Euros ---------------------------- A Step 2 : Given Cross Rate (is the observed numbers in marketplace) EURO/GBP = 0.3985(bid=buy):0.4000(ask=sell) Now this means that EURO/GBP = 0.3985 i.e. 1 GBP = 0.3985 EURO i.e 1 Pound buys 0.3985 Euros --------------------------------- B Comparing A (Ideally) and B (Actual Observed) we can see that In the market 1 Pound buys 0.3985 Euros but ideally it should have the buying power to buy 0.4975 Euros. So that means Euro is overvalued as Pound is buying little Euros than what it should ideally be buying. - 4.25 AM (ET)
thanks. i really really really appreciated that.
You try to make profit out of arbitrage: Here are simple 3 steps: 1. Convert Dollars to Pounds-BUY (use ask) = 1000/2.01 = 497.5124 2. Convert Pounds to Euros -BUY (use ask) = 497.5124/0.4 = 1243.781 3. Convert Euros to Dollars -SELL (use Bid) = 1243.781/1 = 1243.781 Net Profit => 1243.781 - 1000 = $ 243.781 If you work counter clock you end up with $204.19 loss.
Is there a right direction to go first? I am comfortable with the calculations, but the first time I did it, I got the $204.19 loss. Obviously this isn’t one of the choices, so I tried it the other way and got the $243. So, my question, if you are faced with this question, how do you know which way to go around the triangle? Or if you get a loss, do you simply turnaround and go the other way and know you’ll get the right answer the next time? If I can save the steps (and time) of going the wrong way, that would help.
do the implied cross arbitrage for any exchange rate and buy low currency sell high currency. if we invested , it would be in this order: , overvalued currency, undervalued currency, $
big ups to to: bannisja for illustrating: " you always make yourself worse off- so you multiply by the lower # or divide by the bigger # " char-lee: awesome diagram Now I understand triangular arb w bid-ask spreads
char - that was increadibly helpful - cheers. I’ve been struggling with which was round that should go. Even if I’m struggling to understand the money flows this should help to remember which way round
nice one guys