Question

Suppose the exchange rate is such that 1 U.S. dollar equals 1 euro in New York and 0.9 euros in Paris. An arbitrageur would sell euros _____ a. in New York and buy U.S. dollars in Paris. b. in both Paris and New York at different prices. c. in New York while buying them in Paris. d. in Paris while buying them in New York. e. at the same price in both cities.

Answer 1

Answer: d. in Paris while buying them in New York.

Explanation:

An arbitrageur aims to make a profit by trading in different markets where prices are different.

To take advantage of this opportunity, the arbitrageur would sell Euros in Paris where they know they will be able to get more U.S. dollars because the dollar is weaker there.

Once they get more dollars in Paris than they would have gotten in New York, they will then take those dollars to new York where they will be able to buy more Euros than they sold because the dollar is now on par with the Euro.

Gain:

In Paris using 1 Euro they were able to buy = 1 / 0.9 = $1.11

In New York they bought back the 1 Euro for $1.

Gain = 1.11 - 1 = $0.11