Question
Part 1: Today, AUD/JPY spot is trading at 68.1700. At a 150-day investment horizon, the AUD interest rate is 5.40% and the JPY interest rate
Part 1: Today, AUD/JPY spot is trading at 68.1700. At a 150-day investment horizon, the AUD interest rate is 5.40% and the JPY interest rate is 0.30%. From the Covered Interest Rate Parity (CIRP), you know that this implies that the 150-day forward rate must be AUD/JPY = in order to prevent arbitrage.
Case 1: If the actual quoted forward rate was above this level, you could
a) Sell spot, buy forward, borrow terms currency, invest in base currency
b) Buy spot, sell forward, borrow terms currency, invest in base currency
c) Sell spot, buy forward, borrow base currency, invest in terms currency
d) Buy spot, sell forward, borrow base currency, invest in terms currency
e) None of these strategies will result in profits.
to take advantage of this.
Case 2: If the actual quoted forward rate was below this level, you could
a) Sell spot, buy forward, borrow terms currency, invest in base currency
b) Buy spot, sell forward, borrow terms currency, invest in base currency
c) Sell spot, buy forward, borrow base currency, invest in terms currency
d) Buy spot, sell forward, borrow base currency, invest in terms currency
e) None of these strategies will result in profits.
to take advantage of this.
Part 2: Part 1 left out the real-world complication of two-way quotes in the FX market, e.g. in case 2, you need to (buy /sell) the spot rate at the (bid/ask) and (buy/sell) the forward rate at the (bid/ask) .
Part 3: Today, AUD/JPY spot is actually trading at 68.1700-68.2300. Interest rates are as before. Compute the 2 no-arbitrage bounds for the forward rate that the two-way spot rates imply (you will see why they are called no-arbitrage bounds in part 4):
Lower bound: AUD/JPY = ()
Upper bound: AUD/JPY = ()
Part 4: For an arbitrage trade to be possible, the actual forward rate quoted to you must fulfil one of the 2 conditions below:
To exploit case 1, the (bid/ask) of the forward rate must be (above /below) the (lower /upper) bound implied by the (bid/ask) of the spot rate.
To exploit case 2, the (bid/ask) of the forward rate must be (above /below) the (lower /upper) bound implied by the (bid/ask) of the spot rate.
Can someone help solve this and explain this?? Thank you!
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