(SOLVED) A trader, who is considering uncovered interest arbitrage between the US dollar (USD) and Australian dollar (AUD), faces the following data:

Discipline: Finance

Type of Paper: Question-Answer

Academic Level: Undergrad. (yrs 1-2)

Paper Format: APA

Pages: 1 Words: 145

Question

A trader, who is considering uncovered interest arbitrage between the US dollar (USD) and Australian dollar (AUD), faces the following data:


Funds available:     2 million USD


Spot exchange rate:    0.94 AUD per USD


Spot exchange rate one year ago:    1.00 AUD per USD


USD 3-month interest rate:     0.12% per annum


AUD 3-month interest rate:  4.69% per annum


   (1) Calculate the profit that would be made if the exchange rate remains at its current level in three months' time;


Borrow USD 2,000,000 for 3 months. USD to repay after 3 months


= 2,000,000 (1 + (0.12% * (3/12)))


= USD 2,00,600


Convert the borrowed USD into AUD at the spot exchange rate.


AUD received = 2,000,000 * 0.94


= AUD 1,880,000


Invest the AUD for 3 months.


AUD received after 3 months = 1,880,000 (1 + (4.69% (3/12))) = AUD 1,902,043


After 3 months convert the AUD back into USD.


USD received = 1,902,043/0.94


= USD 2,023,450


Profit = USD received after 3 months - USD to repay after 3 months Profit


Profit = 2,023,450 - 2,000,6000 Profit = USD 22,850


(2) How would the profit figure change if the Australian dollar continues to strengthen at the same rate as it has done over the past year?


Expert Solution Preview


In the example given in the question we assume that foreign exchange rate remains the same for 3 months at 0.94 AUD/USD.


Let us calculate the AUD appreciation percentage.
Appreciation/Depreciation formula = (value of previous year - value of this year\frac{}{})/value of previous year
= (1AUD/USD- 0.94AUD/USD)/1AUD/USD) = 0.06 = 6%


If the value is negative then the currency has...............