Consider the following: $\begin{array}{lc}
\text { Risk-free rate in the United States } & \text { 0.04 / year } \
\text { Risk-free rate in Australia } & \text { 0.03 / year} \
\text { Spot exchange rate } &1.67A\$/\$\
\end{array}$

If the market futures price is 1.69 A$/$, how could you arbitrage?
A) Borrow Australian dollars in Australia, convert them to dollars, lend the proceeds in the United States, and enter futures positions to purchase Australian dollars at the current futures price.
B) Borrow U.S. dollars in the United States, convert them to Australian dollars, lend the proceeds in Australia, and enter futures positions to sell Australian dollars at the current futures price.
C) Borrow U.S. dollars in the United States, invest them in the U.S., and enter futures positions to purchase Australian dollars at the current futures price.
D) Borrow Australian dollars in Australia and invest them there, then convert back to U.S. dollars at the spot price.
E) There is no arbitrage opportunity.

Question

Consider the following: $\begin{array}{lc}
  \text { Risk-free rate in the United States } & \text {  0.04 / year } \
 \text { Risk-free rate in Australia } & \text {   0.03 /  year} \
  \text { Spot exchange rate } &1.67A\$/\$\
\end{array}$

If the market futures price is 1.69 A$/$, how could you arbitrage?
A) Borrow Australian dollars in Australia, convert them to dollars, lend the proceeds in the United States, and enter futures positions to purchase Australian dollars at the current futures price.
B) Borrow U.S. dollars in the United States, convert them to Australian dollars, lend the proceeds in Australia, and enter futures positions to sell Australian dollars at the current futures price.
C) Borrow U.S. dollars in the United States, invest them in the U.S., and enter futures positions to purchase Australian dollars at the current futures price.
D) Borrow Australian dollars in Australia and invest them there, then convert back to U.S. dollars at the spot price.
E) There is no arbitrage opportunity.

Quizplus · Accepted Answer

The arbitrage opportunity arises because the futures price is higher than the no-arbitrage price implied by the interest rate differential. By borrowing Australian dollars, converting them to U.S. dollars, and investing at the higher U.S. interest rate, you can lock in a profit by entering a futures contract to buy back Australian dollars at the higher futures price.

Consider the Following If the Market Futures Price Is 1