Question

Currently, the spot exchange rate is $0.85/A$ and the one-year forward exchange rate is $0.81/A$. 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$1,176,471, which is equivalent to $1,000,000 at the current spot rate. a. Determine if IRP is holding between Australia and the United States. b. If IRP is not holding, explain in detail how you would realize certain profit in U.S. dollar terms.

Answer 1

a. $0.81 ÷ A$

b. $42,035.31

Step-by-step explanation:

a. Current Spot Rate = $ 0.85 ÷ A $,

Interest Rate of US = 3.5%

Interest Rate of Australia = 4.2%

If IRP holds, so the one-year forward exchange rate

= 0.85 × [(1.035) ÷ (1.042)]

= $0.844 ÷ A $

Therefore, the actual forward rate is $0.81 ÷ A$, it indicating that International Fisher Effect does not hold .

b. As we can observe in part a., the IRP is not holding, therefore offering an opportunity to benefit from arbitrage. The same can be done as mentioned hereafter:

Borrow A$1,176,471 at the Australian Interest Rate of 4.2%.

Borrowing creates repayment liability worth (A$1,176,471 × 1.042)

= A$1,225,882.78 after one year

Convert the loan into $at current spot rate = $0.85 ÷ A$ to yield

= (A$1,176,471 ÷ 0.85) ~ $1,000,000

Invest the converted $balance for one year at a US interest rate of 3.5%

= $1,000,000 × 1.035

= $1,035,000

After one year convert the investment yield of $1,035,000 into A $ at the forward rate of $0.81 ÷ A $ to yield = $1,035,000 ÷ 0.81

= A$1,277,778.22

Arbitrage Profit = A$1,277,778.22 - $1,225,882.78

= A $51,895.44 or

($51,895.44 × 0.81)

= $42,035.31