Problem 2
A foreign exchange trader obtains the following information for the Australian dollar (AUD) and USD:
Spot exchange rate (AUD/USD) 0.9725
Three-month forward exchange rate (AUD/USD) 0.9875
Three-month interest rate in the United States 4% per annum
Three-month interest rate in Australia 6% per annum
a) Does Covered Interest Parity (CIP) hold?
b) If CIP does not hold, clearly outline the steps you would follow in order to make arbitrage profits in this situation and calculate the profitassuming the trader has access to AUD1 million.
c) Assume that the expected inflation rate in Australia over the next three months is
0.75% (that is the price level is expected to rise by 0.75% over the next three months). If
Purchasing Power Parity (PPP),Uncovered Interest Parity (UIP), and Real Interest Parity
(RIP) hold, what would you expect the inflation rate in the United States to be over the
next three months?
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