Question
Assume the spot exchange rate of the Australian dollar is USD0.6215 and that three-month continuously compounded risk-free rates are 5.0% p.a. and 5.5% p.a. in
Assume the spot exchange rate of the Australian dollar is USD0.6215 and that three-month continuously compounded risk-free rates are 5.0% p.a. and 5.5% p.a. in the US and Australia, respectively.
(a) What is the theoretical price of a three-month forward contract on the Australian dollar? Round your answer to four decimal places.
(b) Assume that the actual three-month forward rate is USD0.6185. Show in detail how an arbitrageur initially borrowing either NZD 1 million or USD 1 million could take advantage of this pricing discrepancy to generate a profit through arbitrage. Make sure that you clearly identify the profit accruing to the arbitrageur at the expiration of the arbitrage strategy.
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