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Identify the current price of a Honda American Depository Receipt (ADR), the price of a Honda share listed on the Tokyo Stock Exchange (TSE), and the current Yen to Dollar exchange rate. Using these data points, calculate the no-arbitrage U.S. dollar price of one ADR at the current exchange rate. Then, compare the ADR's dollar price to the equivalent value derived from the Honda stock price in Yen converted at the current exchange rate. Assess whether an arbitrage opportunity exists based on price discrepancies.

If a potential arbitrage exists, develop a trading plan to exploit this opportunity. Include detailed calculations, such as converting the Honda stock price in Yen to USD and comparing it to the ADR price to determine if buying the cheaper asset and selling the more expensive one would be profitable. Discuss the risks involved and the practical considerations necessary for executing such arbitrage, including transaction costs and market efficiency factors.

Paper For Above instruction

In the interconnected world of international finance, arbitrage opportunities tend to be fleeting due to the efficient functioning of global markets. However, under certain circumstances, differences in prices of equivalent assets across different markets can allow for arbitrage profits. This paper explores the possibility of such an opportunity involving Honda's American Depository Receipt (ADR), its stock listed on the Tokyo Stock Exchange (TSE), and the current Yen to USD exchange rate. The goal is to determine whether an arbitrage profit exists and how a trader might exploit it.

To perform this analysis, the first step involves gathering current market data: the price of Honda ADRs traded on U.S. exchanges, the price of Honda shares on the TSE, and the prevailing Yen/USD exchange rate. For example, suppose the Honda ADR is quoted at USD 50 per ADR, the Honda share on the TSE is priced at 6,000 Yen, and the exchange rate is 110 Yen per USD. These figures serve as basis points for the calculations, though actual figures should be obtained from reliable financial data sources at the time of analysis.

Next, the no-arbitrage price of Honda’s ADR in USD can be calculated by adjusting the stock price on the TSE for the exchange rate. Since one ADR typically represents a fixed number of shares (often one share per ADR), the theoretical USD value of a Honda share is obtained by multiplying the Yen price by the exchange rate, then comparing it to the ADR price. Using the example figures, the USD valuation of one Honda share in Yen terms is:

USD equivalent of Honda stock = 6,000 Yen / 110 Yen per USD ≈ USD 54.55

This calculation suggests that if the Honda ADR is trading below USD 54.55, an arbitrage opportunity exists whereby purchasing the ADR and simultaneously short selling the equivalent Honda stock (or vice versa) could yield a riskless profit. Conversely, if the ADR is priced above USD 54.55, the arbitrage opportunity would favor buying the Honda stock in Yen, converting it to USD, and selling the ADR.

The key aspect is identifying the mispricing between the ADR and the directly comparable Honda stock price. If, for example, the current ADR price is USD 50, traders could purchase ADRs at that price and synchronously short the equivalent amount of shares on the TSE, converting Yen at the current rate, to lock in a profit. Similarly, if the ADR price is USD 60, traders could buy Honda shares in Yen, convert to USD, and sell the ADR in the U.S. market.

However, practical arbitrage trading involves transaction costs, such as brokerage fees, currency conversion fees, and bid-ask spreads. These costs can erode or eliminate potential profits. Additionally, market liquidity, timing delays, and regulatory constraints can influence the feasibility of executing arbitrage strategies effectively. Arbitrageurs must carefully evaluate these factors before assuming the existence of riskless profit.

In conclusion, based on current market data and exchange rates, the identification of a price discrepancy between Honda’s ADR and its underlying stock in Yen provides a potential arbitrage opportunity. If the USD equivalent of the stock's Yen price deviates significantly from the ADR's USD price—beyond transaction costs—traders can develop strategies to capitalize on this discrepancy. The process highlights the importance of real-time data, transaction cost analysis, and market efficiency considerations in arbitrage activities.

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