Question

Currently, the spot exchange rate is $0.75/A$ and the one-year forward exchange rate is $0.70/A$. One-year interest is 3.5% in the United States and 4.2% in Australia. You may borrow up to $1,000,000 or A$1,333,333, which is equivalent to $1,000,000 at the current spot rate. Explain in detail how you would realize certain profit in US dollar terms.

Answer #1

As per interest rate parity

(1+i)/(1+h) = F/S

(1+3.5%)/(1+4.2%) = F/0.75

Theoratical Forward Rate is 0.74 where as quoted Forward rate is 0.74 hence there is arbitrage opportunity available by investing in Australian $ (Strong currency)

Flow will be as follow;

Borrow US $ 1,000,000 @ 3.5%

Convert US $ to AU $ @ Spot of $ 0.75/AU % = 1,333,3333

Invest at 4.2%

Enter a forward contral to sell the Australian $ @0.70

After 1 year;

Interest income from Australian Investment is AU $ 1,333,3333 X 4.2% = 56,000

Therefore total value is 1,333,333+56,000 = 1,389,333

Convert at forward rate i.e. $0.70/AU $ = 1,389,333 X 0.70 = 1,042,000

Repay along with interest in US i.e 1,000,000 + 35,000 = 1,035,000

Therefore risk free net profit is $,7,000

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