Assessment of Potential Arbitrage Opportunities
Recall that Blades, a U.S. manufacturer of roller blades, has chosen Thailand as its primary export target for Speedos, Blades’ primary product. Moreover, Blades’ primary customer in Thailand, Entertainment Products, has committed itself to purchase 180,000 Speedos annually for the next 3 years at a fixed price denominated in baht, Thailand’s currency. Because of quality and cost considerations, Blades also imports some of the rubber and plastic components needed to manufacture Speedos from Thailand.
Lately, Thailand has experienced weak economic growth and political uncertainty. As investors lost confidence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the country. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange market, which put downward pressure on the baht’s value. As foreign investors continued to withdraw their funds from Thailand, the baht’s value continued to deteriorate. Since Blades has net cash flows in baht resulting from its exports to Thailand, a deterioration in the baht’s value will affect the company negatively.
Ben Holt, Blades’ CFO, would like to ensure that the spot and forward rates Blades’ bank has quoted are reasonable. If the exchange rate quotes are reasonable, then arbitrage will not be possible. If the quotations are not appropriate, however, arbitrage may be possible. Under these conditions, Holt would like Blades to use some form of arbitrage to take advantage of possible mispricing in the foreign exchange market. Although Blades is not an arbitrageur, Holt believes that arbitrage opportunities could offset the negative impact resulting from the baht’s depreciation, which would otherwise seriously affect Blades’ profit margins.
Holt has identified three arbitrage opportunities as profitable and would like to know which one of them is the most profitable. Thus, he has asked you, Blades’ financial analyst, to prepare an analysis of the arbitrage opportunities he has identified. This would allow Holt to assess the profitability of arbitrage opportunities very quickly.
Why are arbitrage opportunities likely to disappear soon after they have been discovered? To illustrate your answer, assume that covered interest arbitrage involving the immediate purchase and forward sale of baht is possible. Discuss how the baht’s spot and forward rates would adjust until covered interest arbitrage is no longer possible. What is the resulting equilibrium state called?
We need at least 10 more requests to produce the solution.
0 / 10 have requested this problem solution
The more requests, the faster the answer.