You are working in the Forex Division of Flaggy Bank, Melbourne. You regularly report to your boss, the Manager of the Treasury and Forex Division. Suppose you observe the following interest rates, exchange rates and inflation rates between Australia and the UK.

3-month (annualized) interest rates in Australia and the UK are 7% and 3%, respectively.

Spot and 3-month forward exchange rates, respectively, are A$1.80/ and A$1.85/.

Inflation rates in Australia and the UK are 4% and 5.5%, respectively.

Using the above information,

(a) Could you advise your manager whether interest rate parity (IRP) holds between Australia and the UK? (Must show your calculations to advise your manager). If IRP does not hold, from where do you recommend that your bank should borrow and invest and why?

(b) Assuming no transaction costs, what would your banks covered interest arbitrage profit (or loss) be on the borrowed amount of A$1 million or dollar-equivalent pound? (Must show your workings)?