CFA Level I · CFA Level I Exam · Capital Flows and the FX Market
The spot GBP/USD rate is 1.2500 and the spot EUR/USD rate is 1.0000. A dealer quotes GBP/EUR at 1.2700. An arbitrageur starting with GBP 1,000,000 and trading through the three currencies in the most profitable direction would earn a risk-free profit closest to:
The profit is about GBP 16,000. The quoted GBP/EUR of 1.2700 exceeds the implied cross of 1.2500, so converting GBP to EUR to USD and back to GBP turns 1,000,000 into 1,016,000.
- AGBP 8,000
- BGBP 16,000Correct
- CGBP 20,000
Explanation
The implied cross rate is GBP/EUR = 1.2500/1.0000 = 1.2500, below the quoted 1.2700. Sell GBP at the quoted 1.2700: 1,000,000 GBP gives 1,270,000 EUR, then EUR to USD at 1.0000 gives 1,270,000 USD, then USD to GBP at 1.2500 gives 1,016,000 GBP. Profit is GBP 16,000. The 20,000 figure uses the rate gap of 0.02 on 1,000,000 without converting back.
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