1. You want to invest $5,000,000 for 180 days. Assume you can invest in Australian dollarsat 6% per annum and in U.S. dollars at 1% per annum. The current spot rate is AU$/$ 1.28and the 180-day forward rate is AU$/$ 1.2907.
(a) Would you invest in Australia or in the United States? Why? Describe yourstrategy and quantify the arbitrage profit, if any.
(b) Does covered interest parity hold? Why?
(c) Does your answer a) change if you start with AU$5,000,000? Why?
2. Consider Problem 2, again. Assume your colleague invested $5,000,000 in the Australianmarket for 180 days and hedged FX risk via a forward contract. You invested $5,000,000in Australia as well, but decided to take FX risk by trading in the spot market (“waitand see”). 180 days later, one U.S. dollar is worth AU$1.30.
(a) Did you make an arbitrage profit or a loss? Why?
(b) Who made the smartest trade? Why?