CFA Practice Question

There are 253 practice questions for this study session.

CFA Practice Question

The US$ is currently selling for A$1.2694. Interest rates in the U.S. and Australia are 3.5% and 4.25% respectively. If the US$ is quoted at A$1.2782 in the 1-year forward market, which of the following statements is TRUE?
A. Borrow money in the US, lend it in Australia and simultaneously sell the A$ in the forward market for a guaranteed profit of $0.0005 for every US$ borrowed.
B. Borrow money in the US, lend it in Australia and simultaneously sell the A$ in the forward market for a guaranteed profit of $0.0003 for every US$ borrowed.
C. Borrow money in Australia, lend it in the U.S. and simultaneously sell the US$ in the forward market for a guaranteed profit of A$0.0004 for every US$ borrowed.
Explanation: Borrow one US$ and convert it into A$1.2694 in the spot market. Simultaneously sell the A$ in the forward market at A$1.2782/US$. Invest in Australia and receive A$1.3233 (= 1.2694 x 1.0425) after one year. Exercise the forward contract and sell A$ to receive US$1.0353 (= 1.3233 / 1.2782). In the meantime, the borrower will owe US$1.035 (= 1 x 1.035), pocketing a difference of US$0.0003 (1.0353 - 1.0350).

User Contributed Comments 4

User Comment
malley I think the forward calculation should be: 1.32335 AUD * 1.2782 = 1.69151 USD. anybody?
damonb Malley, 1 USD = 1.2782 AUD. Therefore to find out how many USD's are in 1.32335 AUD's you need to divide it by the AUD equivalent of 1 USD (i.e. 1.2782 AUD). hope this helps.
REITboy How's the best way to determine which currency to borrow? Always the lowest-rate one? (Which would make sense...)
cminor Buy whichever is underpriced and sell whichever is overpriced. In this example, the dollar is underpriced in the forward relative to parity so you lock in the right to purchase forward and then take opposites to complete the trade.

Buy $ forward/Sell A$ forward => Sell $ spot, Buy A$ spot

Hold/invest the currency that you are selling, $A, invest at the rate by borrowing in $

Calc the arb gains
You need to log in first to add your comment.