International Financial Management: Exchange Rates, Triangular Arbitrage, Purchasing Power Parity, and Country Risk Analysis

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International Financial Management

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Part A:
Question 1:
A:
Given Exchange Rate: EURUSD = 1.1 it means 1 Euro = 1 US Dollars
Increase of 2% value of dollar is equal to 1$ * 102% = $1.02
New Exchange rate: (Euro 1.1/US Dollar 1)* US Dollar 1.02 = 1.122/1 it means EURUSD =
1.1220 (Deegan, 2013)
B:
Exchange Rate given:
It means EUR/USD = 1.1043/1 and GBP/USD = 1.2970/1 (Berger and
Harjes, 2009)
Cross Exchange Rates= GBP/USD divided by EUR/USD which means 1.2970/1 divided by
1.1043/1 it can also be expressed as GBP/USD multiplied by USD/EUR (Jakab, Lukyantsau and
Wang, 2015)
So, on the basis of above calculation GBPEUR = 1.1745
EURUS
D
1.104
3
GBPUS
D
1.297
0
USDEU
R
0.905
6
GBPEU
R
1.174
5
EURUS
D
1.104
3
GBPUS
D
1.297
0

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C:
Triangular arbitrage occurs when there is discrepancy between three currencies (Foreign
Currencies) and currency exchange rates do not match up with each other. Arbitrage can be
referred to an opportunity that arises in the financial market when similar asset can be purchased
and sold at the same time in different prices due to exchange rate difference (Borio, 2014).
Triangular arbitrage is also known as three points arbitrage or cross currency arbitrage that can
provide profit to the arbitrator when he uses three or more currencies to make profits. There is
great role of cross currency calculation while arbitrator uses triangular arbitrage in order to make
more profits. The process performing the triangular arbitrage is given as under:
 Arbitrator has to find the opportunity of triangular arbitrage that involves minimum of
three interrelated currency pairs
 After that there is need to find out the cross currency rates and also the implied cross
rates.
 In case if arbitrator finds that there is difference in the rates in above step than he must
trade the home currency or base currency for a second currency in order to change the
currency value
 After changing the base currency in second currency, arbitrator must go for change of
second currency in third currency and this process is followed for number of currency
taken into consideration
 After all the conversion to the last currency, arbitrator arrives at the stage where he can
book the profits. The profit has been arises due to imbalance that exists in the exchange
rates across the three pairs of currencies taken into consideration
 At final stage arbitrator can take the profit through converting the third currency back
into the home currency. This process is very safe but requires complete knowledge of
arbitrage and cross currency exchange rates.
On the basis of above information it can be said that there is direct relation of cross
currency exchange rate and triangular arbitrage because without direct application of cross
exchange rates in the triangular arbitrage process. So it can be said that cross exchange rate

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calculation is required for doing the triangular arbitrage as there are three currencies involved in
triangular arbitrage and calculation to needed to find what benefit change from base currency to
third currency will provide to arbitrator (Madura, 2007).