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Tuesday, June 21, 2011

Australian Dollar and IRP

My students frequently ask me about Interest Rate Parity in what they call “the real world”. They are eager to know if this arbitrage blah blah can help them make money. The Australian dollar is on fire, needless to mention its New Zealand cousin. Take a look at the following chart (from yahoo finance). For the last 3 months the AUD and NZD have risen 6 and 12 percent respectively against the dollar. (Nice return!) During the same time frame an investment in the SP&500 would have lost value (2 percent), while the Euro was barely above 0.

According to the interest rate in Australia has been 4.75% since November 2010 while the FED has set the rate in the US at 0.25% since December of 2008. Tempting… isn’t it? One should borrow in the USD and deposit (lend) that money in AUD.

So what if a student had borrowed $1,000,000 and used the money to buy AUD back in March 2011?

On March 21st the student would have borrowed $1,000,000 at 0.25% and bought Aussies at the going exchange rate. According to Oanda, the bid /ask rates were 1.0037/47 AUD to get 1 USD. Therefore USD1,000,000 would have bought AUD1,003,700. The student would have the deposited the money in an Australian Bank earning 4.75%. At the end of the 3 months this is what we have.

a)      Owed to American Bank: USD 1,000,000 x (1+(0.0025/4))=$1,000,625, this needs to be paid on June 21st .(today)

b)      To be received from Australian Bank: AUD1,003,700 x (1+(0.0475/4))=AUD1,015,618.94, which would have to be exchanged at today’s rate. Again, according to Oanda, the bid /ask rates are 0.9465/67 AUD per 1 USD. Our student would get a total of  resulting in a total of USD1,072,799.13

Our student would now pay the loan to US bank and clear USD72,174 in profit. Not bad... I don't even want to do the numbers for the NZD. Not bad but not riskless either.
Here is when I break the news. Our student spent 3 months with a long open position on the AUD. It could have gone either way. To lock the exit of the position we must have bought a forward contract to purchase the USD back... and that is the end of the profit.

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