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CFA Level I · CFA Level I Exam · Exchange Rate Calculations

A dealer quotes USD/EUR at 1.2000 and GBP/EUR at 0.8500 (price of 1 EUR in GBP). An interbank quote for USD/GBP (price of 1 GBP in USD) is 1.4000. Relative to the implied cross rate, the interbank USD/GBP quote is most likely:

The implied USD/GBP rate is 1.2000 divided by 0.8500, or 1.4118. The quoted 1.4000 is below this, so pounds are cheaper in the interbank quote than the cross rate implies. The pound is undervalued there, and an arbitrage opportunity exists.

  1. Aequal to the implied cross rate, so no arbitrage exists
  2. Babove the implied cross rate, so GBP is overvalued in the interbank quoteCorrect
  3. Cbelow the implied cross rate, so GBP is undervalued in the interbank quote

Explanation

Implied USD/GBP = 1.2000/0.8500 = 1.4118. The quoted 1.4000 is lower than 1.4118, so GBP is cheaper in the interbank quote than implied, meaning it is undervalued there.

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