1. Suppose that annualized interest rates on 3-month CD’s in the U.S. are .375% while in the Australia annualized interest rates on 3 month deposits are 1.10%
a) What must currency traders expect to happen to the exchange rate of the US $ in terms of the amount of Australian $ it buys over the next three months if there is equilibrium in the currency markets at this interest rate differential? You may assume that currently 1AUS $ is worth 75 US cents.
b) In currency markets the “carry trade” refers to borrowing in a currency with low short term interest rates, exchanging that currency for one with higher yielding short term financial instruments and investing in those higher yielding instruments. Why is this considered to be a “risky” trade?