Part (a) A speculator writes (or sells) a call option on the Australian dollar (AUD) at an exercise exchange rate (or strike price) of 0.6500 (USD/AUD). The size of the option contract is AUD 125,000. The premium is USD 0.0040 per AUD. Ignore all interest rates.

(i) At which spot exchange rate on the expiration date will the speculator break even?

(ii) Assume that the spot exchange rate on the expiration date is 0.6600 (USD/AUD). Calculate the value of the call option and the speculator's net profit/loss.

Part (b)

A foreign exchange trader obtains the following information for the Australian dollar (AUD) and the USD: Spot exchange rate (AUD/USD) 1.5400 6- month forward exchange rate (AUD/USD) 1.5300 6-month interest rate in the United States 6% per annum 6-month interest rate in Australia 4% per annum

(i) Does Covered Interest Parity (CIP) hold?

(ii) If CIP does not hold, clearly outline the steps a trader should follow in order to make arbitrage profits and calculate the profit assuming the trader can borrow up to AUD 1,500,000 and can also borrow up to USD 1,000,000.

(iii) Assume that the expected inflation rate in Australia over the next 6 months is 1.5%. If the Purchasing Power Parity (PPP), Uncovered Interest Parity (UIP) and Real Interest Parity hold, what will you expect the inflation rate in the United States to be over the next 6 months?

Answer rating: 100% (QA)

Part a i To break even the spot exchange rate on the expiration date should be equal to the exercise ... View the full answer