Final Exam Test Question
I had a final exam question come up today in a graduate level class for my MBA that read as follows:
Suppose your an FX trader. You follow the Australian Dollar (AUD) and US exchange rate. Assume the spot rate is 1.7 AUD/$ and the forward rate is 1.05 AUD/$. As a trader you believe the spot rate a month from now will be 1.3 AUD/$. How would you trade to make a profit?
A) Buy AUD long B) Sell AUD short
I put B and was marked wrong.
My professor is adamant about B being the correct answer. Is there a way she could somehow be "right." Any thoughts on this would be much appreciated!
First of all who constructs a 1m forward rate that in -65 big figures... ignoring the fact that it's 60 big figures higher than AUDUSD has ever been.
Why would you buy AUD if it's going to take more of it to get the same amount of dollars? AUD going from 1.7 to 1.05 indicates that less AUD can buy the same dollar. You are betting it will take more AUD to buy the same dollar, so you are betting AUD will depreciate in value, so you sell it.
Your professor is correctamundo. I think you're just getting tripped up on notation brosky. The notation AUD/$ means "dollars per aussie dollar". 1.7 to 1.3 means you think AUD will get cheaper from a dollar cost perspective.
Why don't you try to explain why you think A is right?
If you think AUDUSD is going down, why would you long at $1.7 when in a month (if you are right) you could get the same thing for $1.3?
What kind of toilet B-school had an exam question that began "Suppose your an FX trader"?
You've got to be kidding me man. This question is as easy as it gets.
Even if you didn't understand that notation, you could have guessed that 1.7 decreasing to 1.3 means "short".
Just forget the part about the forward price Looking only at the spot prices, you would short aud since you think it will go from 1.7 to 1.3
Whachya doin', mayne? Editin your post after you scooped up some responses? Now it doesn't even make sense!
You guys are ignoring the carry. If the forward rate is 1.05 and spot is 1.7 the FX Swap is then -6500, that implies AUD yield is significantly above USD, ie it is extremely expensive to finance the short position (constantly rolling the position to t+2 after settlement) as you need to borrow AUD at a high depo rate (or lend USD at an extremely low/negative level). There really isn't enough information in this question to make a judgement as you do not know what the ACTUAL carry was, but if the forward px was in fact fair (ie the IR were properly priced) then you may have been right that AUDUSD was going lower, but got hosed on the carry.
Source: I'm an FX Options Trader
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