3 You are given the following information Spot exchange rate (AUD/EUR) One-year
ID: 2807649 • Letter: 3
Question
3 You are given the following information Spot exchange rate (AUD/EUR) One-year forward rate (AUD/EUR) One-year interest rate on the Australian dollar One-year interest rate on the euro 1.60 1.62 8.5% 65% (a) Calculate the forward premium and interest differential to show whether there is any violation of CIP? 5 (b) Explain the rule of thumb to make covered arbitrage profit. What strategy should apply so that you can make profit on covered arbitrage? 10 (c) Calculate the interest parity forward rate (AUD/Euro) and compare it with the actual forward rate (AUD/Euro). Calculate interest parity and actual forward rates in euro per one Australian dollar. 5 (d) If arbitrage is initiated, suggest some values for the interest and exchange rates after it has stopped and equilibrium has been reached. 10Explanation / Answer
Under the covered interest rate parity, the following formula must hold true, otherwise there would be an arbitrage opportunity:
F = S * ((1 + if) / (1 + id)).
Where:
id is the interest rate in the domestic currency, or the base currency
if is the interest rate in the foreign currency, or the quoted currency
S is the current spot foreign exchange rate
F is the forward foreign exchange rate
a)
Forward premium =1.62/1.60=1.0125=1.25% forward premium
No arbitrage forward rate = 1.60*1.085/1.065=1.63AUD/EUR
Since 1.63 AUD/EUR is greater than forward rate, there is a Violation of CIP.
b) Rule of thumb is to sell high priced asset and to buy less priced asset. Hence here buy forward option and invest in AUD.
Borrow Euro 100 at 6.5%. After 1 year have to pay =100*1.065=106.5 Euro
Convert into AUD = 100*1.60=160 AUD
Invest in AUD at 8.5%. After one year = 160*1.085 AUD= 173.60
Now convert back into EUR at forward rate= 173.60/1.62=107.16 Euro
Repay 106.50 Euro
Profit= 107.16-106.50= 0.66 Euro arbitrage profit
c)Interest rate parity forward rate shall be:
No arbitrage forward rate = 1.60*1.085/1.065=1.63AUD/EUR
Since 1.63 AUD/EUR is greater than forward rate, there is a Violation of CIP.
In Euro /AUD = 0.613 Euro/AUD
d) Now we can have arbitrage and at the end of arbitrage the values shall converge to no arbitrage rate i.e. 1.63 AUD/Euro
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.