I understand how to calculate aan arbitrage gain if I am told how to start (like “borrow Yen”…) But how can you say there may be an arbitrage opportunity without doing the calculation ? How would you proceed if you are told to calculate the gain of an arbitrage theory during the exam ? Would you randomly start borrowing a currency and compute the gain/loss ? Or do you have any tip to do the right calculation the first time ?
Loup, In an arbitrage situation you will never use your own money, so you will always have to borrow. You will, of course, want to borrow at the lowest rate and not the higher rate. From there it’s just a matter of identifying how you can make a profit given the spot rates and forward rates. This gets more complicated when they include dealer bid-ask spreads but just remember that the dealer always wins.
I ALWAYS diagram these questions out. Just draw a triangle and place the currencies on each point then use arrows to depict the flow of money. I can’t tell you how much this has helped me in solving triangular arbitrage questions.
In triangular arbitrage, you can start with any amount of any currency and earn the same % arbitrage profit if you go around the triangle the right direction. With a borrow and invest in another currency, and then pay off loan, just determine which currency has a positive Foreign Currency Risk Premium and borrow in the currency with the negative FCRP and invest in the currency with the positive FCRP.