Question

3.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. [6 marks]

3.B. Using diagrams explain what will happen to the current spot exchange rate (increase, decrease, or no change) if the forward rate in (A) and the nominal interest rates in two countries remain the same (the answer should have the change in the demand for or the supply of euros in the foreign exchange market and also the value of the for new exchange rate).

Answer 1

	Forward Rate should be :
	1.319*1.005AUD=1*1.0022US$
	1.322685AUD/1US$
	Current Forward Rate :1.376AUD/US$
	Profit can be made by selling USD in forward
	STEP1 SELL USD( 1 *1.0022)million in forward
	STEP 2: Borrow 1.319million AUD at interest rate 0.5% for 90 days
	STEP3: Convert AUD to USd at current spot rate=1.319AUD/US$
	Amount of USD received =1 million
	STEP4 :Invest 1million USD at 0.22% for 90 days
	STEP 5: Amount received in USD after 90 days=1million*1.0022	1,002,200	USD
	STEP6:Amount of AUD to be received =(1.0022*1.376)	1,379,027.20	AUD
	STEP7:Pay back Borrowed AUD along with interrest of 0.5%
	Amount Payable in AUD for borrowing in step 2=(1.319*1.005) million	1,325,595.00	AUD
	Amount of Profit in Australian Dollars=(1379027.20-325595.00)=	53,432.20	AUD