Question

Question 2 - Topic: Exchange Rate Determination

The spot bid-offer rates between Australian dollar and pounds (GBP/AUD) is quoted as 0.5144 – 0.5149. Speculator A expects the exchange rate to be 0.5130 – 0.5140, whereas Speculator B expects the exchange rate to be 0.5150 – 0.5155, in two months from the initial quotes.

a) Based on the expectations of the two speculators, which currency will appreciate and which currency will depreciate from the view of Speculator A, and Speculator B? [3 marks]

b) Determine the appropriate strategy between buy-low-sell-high, and short-sell positions on the AUD that each Speculator (A and B) should take given the bid-offer rates at t = 0 and their respective expected rates t = 2 months, to realize a profit. [4 marks]

c) Based on your answers to part (b), calculate the profit in basis points for the different positions taken by Speculator A and B, respectively. [8 marks]

Please provide explanation. Thanks

Answer 1

spot bid-offer rates :

GBP/AUD = 0.5144 – 0.5149

The bid price is the rate at which the market maker will buy the base currency from a customer/market user.
The offer price is the rate at which the market maker will sell the base currency to a customer/market user.

Expectations after 2 months -

Speculator A = 0.5130 – 0.5140

Speculator B = 0.5150 – 0.5155

A.

As per A, GBP/AUD will decrease in 2 months, as the bid and offers price are expected to reduce. This implies appreciation in GBP and depreciation in AUD.

As per B, GBP/AUD will increase in 2 month, as the bid and offers price are expected to increase.This implies depreciation in GBP and appreciation in AUD.

B.

As A is expecting the AUD to decrease at t =2, so short-sell positions on the AUD would be a better option for him to realize gains through arbitrage. He should sell AUD (against GBP) at t=0 and buy it back at t =2. Thus he can realize gains at t=2 by buying at a low price.

As B is expecting AUD to increase at t=2, he should buy AUD (against GBP) now i.e. at t=0 and sell it later at t=2, when the currency appreciates. At t= 2, he can realize the gains by using Buy-low-Sell -high.

C.

If A sells 1 AUD at t= 0, he gets 0.5144 GBP

At t=2, 0.5144/0.5140 = 1.00078 AUD

So the profit (at t=2) is 0.00078 per AUD sold at t=0. (in currencies, a change of 0.0001 is called a basis point)

so this can be rounded off and called as a change of 0.0008 basis points

If B, buys 1 AUD today, he has to pay 0.5149 GBP

after 2 months, at t =2, he gets 0.5150 by selling this AUD.

So profit is 0.0001 basis points per AUD.

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