Question

Suppose the pound is pegged to gold at 5 pound per ounce, whereas the German Mark is pegged to gold at 15 Mark per ounce. Currently the market exchange rate is 2.5 Mark per pound.

1. What is the implied exchange rate between German Mark and pound? Answer: 1 pound = German Mark (Please write your answer in whole German Mark. Enter just the number without the currency unit).

2. Which of the following strategy will take advantage of this situation? Suppose you are a UK investor and start with 1,500 pound.

3.What is your arbitrage profit (in pound)? Suppose you are a UK investor and start with 1,500 pound

Please round your answers to whole pound.

Answer 1

Note: In Problem 2 it is mentioned "Which of the following strategy will take advantage of this situation"...However, no strategies are provided in the problem. Hence the answer is based on the possible strategy one can think off.

Answer 1

Sine that the pound is pegged to gold at 5 pounds per ounce, whereas the German Mark is pegged to gold at 15 German Marks per ounce. This, of course, implies that the equilibrium exchange rate should be three German Marks per pound. i.e 1 Pound = 3 German Marks

Answer 2

If the current market exchange rate is 2.5 German Marks per pound, for the investor in UK with 1,500 pound, it will be cheaper to first buy gold from the Bank of UK and ship it to Germany and sell if for German Marks. If you buy 300 (1,500/5) ounces of gold from the Bank of UK and ship it to Germany and sell if for 300 x 15 = 4500 German Marks.

Answer 3

4500 German Marks will earn you = 4500 German Marks / 2.5 Mark per pound = 1,800 pounds

Hence, arbitrage profit (in pound) = 1,800 pounds -1,500 pounds =300 pounds (Assuming there was no shipping costs)

Assuming if there was shipping costs then, the arbitrage profit would be less than what is denoted above