Assume that the U.S. one-year interest rate is 3% and the one-year interest rate on Australian dollars is 6%. The U.S. expected annual inflation is 5%, while the Australian inflation is expected to be 7%. You have $100,000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is $0.689. What will be the yield on your investment if you invest in the Australian market?

Question

Quizplus · Accepted Answer

Using the Interest Rate Parity (IRP) formula:

$0.689/$1 = ($1.03/$1.07)

$1 AUD = $0.64368 USD

This means that, according to PPP, the fair exchange rate should be $0.64368. Compared to the current exchange rate of $0.689, USD is overvalued by (0.689-0.64368)/0.64368 = 6.98%.

Therefore, the expected exchange rate at the end of one year is:

$0.689 * (1 + 0.07) / (1 + 0.05) = $0.719

If you invest $100,000 in Australia today, you will receive AUD 145,347 after one year, which will become $145,347*$0.719 = $104,482.

Your yield will be ($104,482-$100,000)/$100,000 = 4.48%, which is closest to (C) 4%.

Assume That the U