Problem
Cornerstone FX is a currency trader that specializes in developing arbitrage strategies. One day the company observes the following quotes for British pound (GBP) and Brazilian real (BRL) in two currency markets, Chicago, US and Sao Paulo, Brazil:
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Chicago
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Sao Paulo
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GBP/USD
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$1.25
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-
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BRL/USD
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$0.25
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$0.25
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GBP/BRL
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-
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BRL 5.2
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Answer questions I and II below.
I. Determine whether there is any potential discrepancy in GBP/BRL exchange rate between the two currency markets. If Cornerstone FX considers developing a triangular arbitrage strategy to exploit such a discrepancy, in which market should it buy GBP and sell BRL simultaneously?
II. Suppose that Cornerstone FX allows its trading desk to use a trading limit of $800,000 on verified arbitrage opportunities. Calculate the riskless profit its trading desk can generate by executing a triangular arbitrage strategy.