Question

A Assume that today is 21 March 2019. Today, you observe that the exchange rate between AU$ and the US$ is 1.319, EAU$/US$=1.319, the 90-day interest rate in Australia is 0.50%, the 90-day interest rate in the US is 0.22%, and the 90-day forward rate is 1.376,FAU$/US$=1.376. Note that the covered interest parity does not hold here. Explain how you can make risk free profits using spot and forward markets in 90 days, on 20 May 2019, if you can either borrow AU$1.319 million Australian dollars or borrow US$1 million dollars with the interest rates above today. The answer should have the exact amount of profits in Australian dollars. Hint: outline all investment steps and show all calculations. Do not forget to pay the principal and interests on 20 May 2019.

Answer 1

Fair forward rate as per Interest rate Parity = Spot Rate*(1+Interest rate AU$)/(1+ Interest rate US $)

= 1.319*(1+0.005)/(1+0.0022)

= AU$1.323/US $

Since the actual forward rate is different from fair forward rate, arbitrage is possible.

Steps:

Borrow AU$1,319,000

Convert into US $ at Spot Rate and get 1,319,000/1.319 = US$1,000,000

Invest and get 1,000,000(1+0.0022) = US $1,002,200

At maturity:

Convert back into AU $ = 1,002,000*1.376 = AU $1,379,027.2

Repay loan AU$ 1,319,000(1+0.005) = AU$ 1,325,595

Arbitrage Profit = AU$53,432.2