Question

Alicia Strong is a foreign exchange dealer for a bank in Australia. She wishes to consider whether International Parity Condition (IPC) holds between the British pound and the Australian dollar. Alicia also wonders whether she should invest in AUD or in British pounds (£) to make a covered interest arbitrage (CIA) profit. Depending on the CIA opportunity, she can borrow either A$1,000,000 or £1,000,000 to invest for the next 12 months. Consider Australia as home market and the UK as foreign market. She faces the following interest rates, exchange rates and inflation rates: Nominal interest rate is 5% in Australia (rh) Nominal interest rate is 2% in the UK (rf). Current spot rate, e0 is A$1.50/£ and 1-month forward rate, f1 is A$1.65/£ Inflation rate in Australia 3.5% Inflation rate in the UK 1.5% Using this information:

i. Given the current spot rate and relative inflation rates for the UK and Australia, what does PPP suggest the future expected spot rate will be?

ii. Does interest parity hold? If not, where do you recommend that Alicia borrow and invest and why?

iii. Assuming no transaction costs, what would Alicia’s covered interest arbitrage profit be on the borrowed amount of A$1,000,000 or £1,000,000 (use 2 decimal points)?

Answer 1

(I) future spot rate is expected to be increase as the inflation rate in Australia is more than the inflation rate in Europe hence the euro is expected to be appreciated and Australian dollar is expected to be appreciated.