Economic - R13 Example 4 Question No. 5

CFA Level II Economics
#1

Hi,

Can anyone explain solution of Example 4 Question number 5 ,

#2

Remember that covered interest rate parity usually holds, and this question is assuming that it does.

The question says they hedged the risk associated with a 1 yr JPY deposit with a forward contract, meaning they bought JPY and and also bought a forward to hedge the risk. (The language is a little odd, but to hedge the risk, the risk has to exist, which means they did buy the JPY). The JPY returns 1% at the deposit rate. and the forward, because the AUD is going to appreciate by 5% and the JPY is going to appreciate by 1%, must appreciate by 4% to make covered interest rate parity hold. So you have 1% from the JPY and 4% from the forward position. so 5% gain total.

#3

There: that’s better.

#4

Thanks bill. So in practice, is it really impossible to make arbitrage profit from a forward contract and rates?

#5

It probably depends on how big you are.

Goldman Sachs probably can, because they have a computer the size of Rhode Island searching constantly for the slightest mispricing on derivatives and exploiting that mispricing instantly.

For the rest of us, consider it impossible.