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Covered interest arbitrage is a well-known strategy for capitalizing on mispricing in the market. The strategy involves borrowing money today in one's home currency, selling
Covered interest arbitrage is a well-known strategy for capitalizing on mispricing in the market. The strategy involves borrowing money today in one's home currency, selling the domestic currency in the spot market in exchange for a foreign currency, investing the foreign currency abroad and simultaneously selling the foreign currency in the forward market to end up with domestic currency. Assume that you have the following information: Spot AUD/CAD =0.9367;1 Year Forward AUD/CAD =0.9200; One-year risk- free rate in Canada =2%; One year risk-free rate in Australia =2.5%. For simplicity, assume that you can both borrow and lend at the risk-free rate. Assume also that if you undertake the strategy you will borrow $100,000CAD. Which of the following statements are true? Select one: a. CAD $100,000 is equivalent to AUD $106,755 at the spot rate b. You should have AUD $109,423.88 after one-year if invested at the Australian risk-free rate C. After converting back to CAD at the one-year forward rate and paying the interest on the Canadian dollar loan, you will have made a "profit" of CAD $1,330 d. All of the above are true e. Only a. and b. above are true Continue with the data from the question above. Using the formula for Interest rate parity, F1=S0(1+RQuote Currency )/(1+RBase Currency ), what one-year Forward Rate should prevail in the market? Select one: a. AUD/CAD=0.9321 b. AUD/CAD=0.9280 C. AUD/CAD=0.9245 d. AUD/CAD=0.9200 e. AUD /CAD=0.9176
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