Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.80 per pound, how would you take advantage of this situation? Hint: assume that you have $350 available for investment.

Question

Quizplus · Accepted Answer

Option A involves buying gold with dollars at the fixed exchange rate of $35 per ounce, and then converting the purchased gold to pounds at the fixed exchange rate of £20 per ounce. The pounds are then exchanged for dollars at the current market rate of $1.80 per pound to yield a profit of $10 ($360 - $350). Option B involves exchanging dollars for pounds at the current market rate, and then buying gold with pounds at the fixed exchange rate of £20 per ounce. The purchased gold is then converted to dollars at the fixed exchange rate of $35 per ounce, which would yield a loss due to the unfavorable market exchange rate. Therefore, option A is the best choice.

Suppose That the Pound Is Pegged to Gold at £20