Today, short-term interest rates in Australia are 8.50% and the corresponding U.S. rate is 6.0%. The current discount on forward Australian dollars is 2.0%. Can a U.S. trader use covered interest arbitrage to take advantage of this situation? If so, what is the net effect?

Question

Quizplus · Accepted Answer

Covered interest arbitrage involves taking advantage of discrepancies between interest rates and exchange rates by borrowing in a currency with a lower interest rate and investing in a currency with a higher interest rate, while simultaneously using forward contracts to protect against exchange rate fluctuations.

In this situation, a U.S. trader can borrow in U.S. dollars at the lower interest rate of 6.0%, convert those dollars into Australian dollars, and invest them in an Australian account at the higher interest rate of 8.50%. The trader can then use a forward contract to sell the Australian dollars back into U.S. dollars at a future date, hedging against any potential changes in the exchange rate.

The discount on forward Australian dollars of 2.0% means that the forward exchange rate for Australian dollars is expected to be 2.0% lower than the current spot exchange rate. This means that the U.S. trader can sell the forward contract at a higher exchange rate than the current spot rate, effectively earning a profit.

The net effect of this covered interest arbitrage is a gain of 1/2%, calculated as follows:

- Invest $100 in Australian dollars at 8.50% for one year, earning $8.50 in interest.
- Borrow $100 in U.S. dollars at 6.0%, paying $6.00 in interest.
- Exchange the $100 U.S. dollars for $100 AUD at the spot rate of 1 AUD = 0.67 USD.
- Invest the $100 AUD at 8.50%, earning $8.50 in interest.
- At the end of the year, receive $109.00 AUD from the Australian investment.
- Sell the $109.00 AUD back into U.S. dollars at the forward rate of 1 AUD = 0.654 USD (2.0% discount from the spot rate).
- Receive $71.44 USD from the forward contract.
- Repay the $100 USD loan plus interest of $6.00 USD.
- Net profit is $71.44 - $106.00 = $4.44 USD, or 1/2%.

Today, Short-Term Interest Rates in Australia Are 8