Assume the following information: Current spot rate of Australian dollar = $.90
ID: 2643113 • Letter: A
Question
Assume the following information:
Current spot rate of Australian dollar
=
$.90
Forecasted spot rate of Australian dollar 1 year from now
=
$.88
1-year forward rate of Australian dollar
=
$.91
Annual interest rate for Australian dollar deposit
=
3%
Annual interest rate in the U.S.
=
2%
What is your percentage return from covered interest arbitrage with $500,000?
Current spot rate of Australian dollar
=
$.90
Forecasted spot rate of Australian dollar 1 year from now
=
$.88
1-year forward rate of Australian dollar
=
$.91
Annual interest rate for Australian dollar deposit
=
3%
Annual interest rate in the U.S.
=
2%
Explanation / Answer
Percentage Return From Covered Interest Arbitrage:
Step 1: Borrow $500,000 at 2% Interest rate in US for 1 Year. Maturity Amount will be: 500,000 x 102/100 = $510,000
Step 2: Convert $500,000 in Australian Dollar at the current Spot Rate: 500,000 / 0.90 = 555,555.556 AD
Step 3: Deposit this 555,555,556 AD in Australia for 1 Year at 3%. Maturity Value will be: 555,555.556 x 103/100 = AD 572,222.223
Step 4: Buy a Forward Contract at $0.91 for the Maturity Value of AD Deposit.
Step 5: Settle Forward Contract at the Contracted Rate: 572,222.223 x 0.91 = $520,722.223
Step 6: Repay the Loan Amount: 520,722.223 - 510,000 = $10,722.223 Will be the return from Covered interest arbitrage.
Percentage Return: 10,722.223 / 500,000 = 2.14%
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