Assume that the pound is pegged to gold at 6 pounds per ounce, while the franc is pegged to gold at 12 francs per ounce. Of course it implies that the equilibrium exchange rate ought be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take benefit of this situation? What would be the influence of shipping costs?
Assume that you need to buy 6 pounds by using French francs. If you purchase 6 pounds directly in the foreign exchange market, this will cost you 13.2 francs. On the other hand, you can first purchase an ounce of gold for 12 francs in France & then ship it to England and sell it for 6 pounds. In this situation, it only costs you 12 francs to purchase 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Certainly, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in foreign exchange market. The arbitrage profit will be 1.2 francs. Thus far, we supposed that shipping costs do not exist. If it expenses more than 1.2 francs to ship an ounce of gold, there will be no arbitrage earnings.