1. Suppose dollar/pound rate is 1.5 in New York, and it is 1.6 in London. What will you do?
Sell dollars in NY to get pounds and then use those pounds to buy dollars in London.
2. Suppose dollar/pound rate is 1.5 and pound/euro rate is 0.8. What do these rates imply for
dollar/euro exchange rates. What will you do if the dollar/euro rate offered directly is
1.25$/euro? What if it is 1.15$/euro.
Dollar/euro exchange rate = 1.5*0.8 = 1.2
If the dollar/euro exchange rate is 1.25, then sell dollars for pounds and then pounds for euros; and then
buy dollars at 1.25 rate. If it is 1.15 then do the opposite.
3. Suppose you have $1 million to invest at 5% in a US bank. Alternatively you can buy euros at a
rate of 1.25$/euro and then make an euro deposit at 10% interest rate. One year forward
exchange rate is 1.2$/euro. What will you do?
US interest rate is 5%; the implied dollar returns from making euro deposits is 0.1 + (1.2-1.25)/1.25 =
0.06 = 6%. Go for euro deposits.