Suppose that the two-year interest rates in Australia and the United States are 5% and 7%, respectively. The spot exchange rate is 0.62 USD (US dollars) per AUD (Australian dollars).

1. What is the theoretical two-year forward rate?

1. Suppose that the two-year forward exchange rate quoted by Trader A is 0.68 USD per AUD, is this forward rate too low or too high? Explain your answer.

Between the two strategies listed below, which strategy should be implemented by an arbitrageur who wants to take advantage of this opportunity? Explain intuitively why the strategy implemented by the arbitrageur is profitable. Do not compute the profit of each strategy.

Strategy 1:

-Borrow 1000 USD at 7% rate for two years, convert to AUD and invest the AUD at 5%;

-Enter into a forward contract with Trader A to sell AUD for USD at rate of 0.68 USD per AUD.

Strategy 2:

-Borrow 1000 AUD at 5% rate for two years, convert to USD and invest the USD at 7%;

-Enter into a forward contract with Trader A to buy AUD for USD at rate of 0.68 USD per AUD.

1. Based on your answer in part (3), compute the arbitrageurs profit in USD and complete the following table.

Action	Cash Flow at t	Cash Flow at T
1. (hint: Borrow USD or AUD?)
2. (hint: Convert __ to __ at the spot rate__?)
3. (hint: Invest USD or AUD?)
4. (hint: Enter forward contacts to convert __for __at the forward rate __)
Total