Question

Question 2 - Topic: Exchange Rate Determination The spot bid-offer rates between Australian dollar and pounds (GBP/AUD) is quoted as 0.5144 – 0.5149. Speculator A expects the exchange rate to be 0.5130 – 0.5140, whereas Speculator B expects the exchange rate to be 0.5150 – 0.5155, in two months from the initial quotes.

a) Based on the expectations of the two speculators, which currency will appreciate and which currency will depreciate from the view of Speculator A, and Speculator B? [3 marks]

b) Determine the appropriate strategy between buy-low-sell-high, and short-sell positions on the AUD that each Speculator (A and B) should take given the bid-offer rates at t = 0 and their respective expected rates t = 2 months, to realize a profit. [4 marks]

c) Based on your answers to part (b), calculate the profit in basis points for the different positions taken by Speculator A and B, respectively. [8 marks]

Answer 1

a. Since Speculator A expects a lower exchange rate, this means according to him/her, AUD will appreciate and GBP will depreciate. Since Speculator B expects a higher exchange rate, this means according to him/her, AUD will depreciate and GBP will appreciate.

b. Since Speculator A expects exchange rate to go down, he/she should take a short sell position so that when the quote goes down he/she can benefit. Similarly, Speculator B should take a long position (buy-low-sell-high) as he/she expects the quote to go up.

c. Speculator A will go short at the price of 0.5144 (bid) and will be able to buy back the position at 0.5140 (ask of expected quote). Hence, his/her profit will be = 0.0004 or 4 pips or 0.04 basis points

Similarly for speculator B, he/she will buy at 0.5149 and will be able to sell at 0.5150. So, net profit = 0.0001 or 1 pip or 0.01 basis point.