Question

#1. Australia runs a fixed exchange rate regime. You work for a hedge fund. You, and many other traders in the hedge fund community, believe that Australia is about to revalue its currency (the AUD) against the US dollar.

Thus, you believe that the AUD will become stronger against the US dollar in the future, although the current spot exchange rate remains unchanged.

Which of the following is likely to occur?

A. Hedge funds will take short positions in the AUD, the money supply will decline, and foreign exchange reserves will fall.

B. Hedge funds will take short positions in the AUD, the money supply will increase, and foreign exchange reserves will rise.

C. Hedge funds will take long positions in the AUD, the money supply will decline, and foreign exchange reserves will fall.

D. Hedge funds will take long positions in the AUD, the money supply will increase, and foreign exchange reserves will rise.

#2. Continuing with the scenario described in the previous question, suppose hedge funds believe the revaluation will occur within the next year. Which of the following is likely to occur with the one-year AUD forward exchange rate, and the one-year Australian interest rate?

The AUD forward rate will appreciate, and Australian interest rates will rise.

The AUD forward rate will appreciate, and Australian interest rates will fall.

The AUD forward rate will depreciate, and Australian interest rates will rise.

The AUD forward rate will depreciate, and Australian interest rates will fall.

Answer 1

1. If Australia revalues it's currency it will make the AUD more expensive as compared to the pegged currency. Any US firm already holding assets using the previous exchange rate will have to revalue the assets at the new exchange rate. Suppose if 10 units of AUD used to be pegged against USD and post revaluation only 5 units are pegged now. The available AUD will be less and assets will be valued less.

So keeping the above in mind, we know that the AUD will increase and get stronger so a hedge fund would take a long position in the currency. As AUD has become costlier, money supply will be less and existing FX reserves will fall. Answer is c.

2. Increase in inflation is one of the effects of a revaluation. So an increase in inflation would ultimately lead to higher interest rates. Answer is a - AUD will appreciate and interest rates will rise.