Question

An Australian company is considering a three month short-term investment of 10,000AUD in either Australia or Switzerland. The following information is available

Initial spot exchange rate (AUD/CHF) 1.0775-1.0825

Australian three month LIBOR rate (deposit – loan) 4.75-5.25% p.a.

Swiss three month LIBOR rate (deposit – loan) 2.25-2.75% p.a.

Australian lending/borrowing spread +1.5%p.a.

Swiss lending/borrowing spread +0.5%p.a.

Required: (a) If the ending spot exchange rate (AUD/CHF) is expected to be 1.0875-1.0925, which financing option should be taken.

(b) If the ending spot exchange rate turned out to be (AUD/CHF) 1.0675-1.0725, would your decision have been profitable.

(c) Determine the profit or loss from your decision.

Answer 1

(a) If we invest AUD 10,000 in Australia for 3-months then return on that investment would be 4.75% + 1.5% spread because investment will earn rate of deposit + spread.

Return after 3-months = 10,000*(4.75%+1.5%)*90/360

= 10,000*0.0625*90/360

= 10,000*0.015625‬ = 156.25

So, at the end of 3-months 10,000 AUD will become 10,000+156.25 = 10,156.25‬ AUD.

If we invest AUD 10,000 in Switzerland for 3-months then first we need to convert AUD in to CHF using spot rate and then return on that investment would be 2.25% + 0.5% spread because investment will earn rate of deposit + spread. At the end of 3-months again we need to convert the investment + return on CHF to AUD using ending spot rate to compare returns earned in Australia and Switzerland.

Current CHF value of 10,000 AUD = 10,000/1.0775 = 9,281 CHF

We need to use spot bid rate of 1.0775 because this the rate at which FX dealer will buy 10,000 AUD from us and give the equivalent CHF. The other rate is Ask rate at which dealer will sell the currency.

Return after 3-months = 9,281*(2.25%+0.5%)*90/360

= 9,281*0.0275*90/360

= 9,281*0.006875‬ = 63.81

Now we convert 9,281+63.81 CHF to AUD using ending spot exchange rate of 1.0875.

Return in AUD = (9,281+63.81)*1.0875 = 9,344.81*1.0875 = 10,162.48 AUD

From above calculations, we can see that 3-months investment of 10,000 AUD in Switzerland gets us 10,162.48 AUD compared to 10,156.25‬ AUD in Australia.

So, we should invest in Switzerland.

(b) If the ending spot exchange rate is 1.0675 then Swiss investment will be worth:

Value of Swiss investment after 3-months = (9,281+63.81)*1.0675 = 9,344.81*1.0675 = 9,975.58 AUD

Due to unfavorable ending spot exchange rate, 3-months investment in Switzerland in AUD is lower than 3-month investment in Australia.

So, our investment in Switzerland will not be profitable.

(c) Loss on 3-month investment in Switzerland = return on investment in Australia - return on investment in Switzerland

= 156.25 AUD - (63.81 CHF * 1.0675)

= 156.25 AUD - 68.12 AUD

= 88.13 AUD

Loss on our earlier decision to invest in Switzerland for 3-months would be 88.13 AUD.