Answers to Assignment# 3
14. Freely Floating Exchange Rates.
Should the governments of Asian countries allow their currencies
to float freely? What would be the advantages of letting their currencies float freely? What would be
ANSWER: A freely floating currency may allow the exchange rate to adjust to market conditions,
which can stabilize flows of funds between countries. If there is a larger amount of funds going out
versus coming in, the exchange rate will weaken due to the forces and the flows may change because
the currency has become cheaper; this discourages further outflows. Yet, a disadvantage is that
speculators may take positions that force a freely floating currency to deviate far from what is
perceived to be a desirable exchange rate.
Assume the following information:
Bid price of New Zealand dollar
Ask price of New Zealand dollar
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational
arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces
would occur to eliminate any further possibilities of locational arbitrage?
ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.400 and sell them to
Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased
at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby
generating a profit of $2,500.
The large demand for New Zealand dollars at Yardley Bank will force this bank’s ask price on New
Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid
price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank,
locational arbitrage will no longer be beneficial.