You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate is quoted as $1.50 = €1.00 and the dollar-pound exchange rate is quoted at $2.00 = £1.00. If a bank quotes you a cross rate of £1.00 = €1.25 how can you make money?

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Quizplus · Accepted Answer

Using cross rates, we can calculate the implied exchange rate between euros and pounds as €1.00 = £1.00/€1.25 = £0.80. This rate is better than the direct exchange rate of €1.00 = $1.50/£2.00 = £0.75. 
Therefore, we can buy euros at $1.50/€ and then buy pounds at €1.25/£1.00 using the purchased euros. Finally, we can sell the pounds at $2.00/£1.00 to get a profit.

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