Question

Part III: Interest Rate Parity and Covered Interest Arbitrage
Assume the following information:

Current spot rate of Australian dollar	=	$.65
Forecasted spot rate of Australian dollar 1 year from now	=	$.69
1-year forward rate of Australian dollar	=	$.68
Annual interest rate for Australian dollar deposit	=	5%
Annual interest rate in the United States	=	8%

1. ​According to Interest Rate Parity, is the covered interest arbitrage feasible to U.S. investors and Australian investors? Please explain your answers (20 points).
2. Suppose an U.S. investor can borrow up to $500,000 to invest and an Australian investor can borrow up to Australian $800,000 to invest. How much is the covered interest rate arbitrage profit for the U.S. investor and Australian investor if the covered interest arbitrage is feasible to them (20 points)?

Answer 1

Part A)-

As per IRPT forward rate shoul be = spot rate*(1+home currency interest rate)/(1+foreign currency interest rate)

Here $ = Home currency ; Aus $ = Foreign currency

Forward rate = $65*(1+0.08)/(1+0.05)

= $65*1.08/1.05

Aus $ 1 = $ 66.8571

Aus $ is over priced in forward market, hence buy or invest in AUS $ today and sell or realise AUS $ after 1 year by using forward market. Covered interest arbitrage exist for US investors.

Part B)-

From point of view of US investors:

Borrow US $ 500,000 @ 8% interest rate p.a for 1 year	US $ 500,000
Convert US $ into AUS $ by using current spot rate (500,000/65) & invest the AUS $ @ 5% p.a for 1 year	AUS $ 7,692.31
At the end of year 1, realise deposit of AUS $ 7,692.31(1.05)	AUS $ 8,076.92
Re-convert AUS $ into US $ by using forward rate of $ 68 (8076.92*68)	US $ 549,231
Repay borrowing with interest (500000*1.08)	US $ 540,000
Book Arbitrage profit	US $ 9,231

From point of view of AUS investors:

Borrow AUS $ 800,000 @ 5% interest rate p.a for 1 year	AUS $ 800,000
Convert AUS $ into US $ by using current spot rate (800,000*65) & invest the US $ @ 8% p.a for 1 year	US $ 32,500,000
At the end of year 1, realise deposit of US $ 32,500,000(1.08)	US $ 35,100,000
Re-convert AUS $ into US $ by using forward rate of $ 68 (32,500,000/68)	AUS $ 516,176.47
Repay borrowing with interest (800000*1.05)	AUS $ 840,000
Book Arbitrage loss	AUS $ 323,823.53