Question

Hey Thanks in advance for any assistance you are able to provide to the following question:

The 3-month interest rates (annualized) in Tokyo and Australia are 1.2% and 6.2%. The local Banks provides a spot rate of ¥87.74 and 90-day forward rate of ¥86.40.

**Show you calculations for all questions**

1. Does interest rate parity hold?

2. Where would you invest?

3. Where would you borrow?

4. With consideration to the exchange quote and interest rate, are there any arbitrage opportunities? Show your profit on a 1 million investment (assume there are no trade costs).

Answer 1

1.

Interest rate parity does not hold

As forward rate is not equal to Spot*(1+JPY*3/12)/(1+AUS*3/12)

Forward rate should be 87.74*(1+1.2%*3/12)/(1+6.2%*3/12)=86.66

2.

Japan

3.

Australia

4.

Borrow 1 AUD

COnvert to 87.74 Yen

Invest in Japan at 1.2%

You will get 87.74*(1+1.2%*3/12)=88.00322 3 months later

As spot rate will converge to froward rate, Convert at forward rate to AUD=88.00322/86.40=1.018556 AUD

Return 1*(1+6.2%*3/12)=1.0155 AUD

Profit=1.018556-1.0155=0.003056 AUD

Per 1 AUD, profit=0.003056 AUD

Hence, for 1 million AUD, profit=3056 AUD