3 You are given the following information: Spot exchange rate (AUD/EUR) One-year
ID: 2807708 • 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% 6.5% 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. 10 (a)Explanation / Answer
a)
The forward spread is: 1.62-1.60/1.60 = 0.0125 = 1.25%
The interest rate differential is : 8.5% - 6.5% = 2%
The forward spread and interest rate differentials are different implying a violation of CIP
b)
As long as the covered margin is non-zero, there is a potential to make arbitrage profit.
The arbitragers should follow the strategy of borrowing EURO and then converting it to AUD and investing it for one year. For example if arbitragers borrow 1000 EUR and that makes EUR 1065 payable in one year. Converting to AUD, 1000 EUR = 1600 AUD and investing it for one year gives AUD 1736. The AUD is converted to EUR at forward rate of AUD/EUR = 1.62 giving EUR 1071.605 thus giving a profit of EUR 1071.605 – EUR 1065 = EUR 6.605 profit
c)
Interest rate parity forward rate = 1.6 * 1.085/1.065 = 1.63
Actual forward rate is 1.62 thus implying violation of CIP
EUR/AUD actual forward rate: 0.6172 EUR/AUD
As per interest rate parity:
(1/1.6)*(1.065/1.085) = 0.6134 EUR/AUD
d)
For arbitrage to end with no change in interest rates, the spot exchange rate should fall to 1.62*1.065/1.085 = 1.590138
For exchange rates to remain same, the interest rate in AUD should change to 1.62*1.065/1.6 -1 = 7.83%
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