Forces of Covered Interest Arbitrage
Response to the following problem:
As of now, the nominal interest rate is 6 percent in the United States and 6 percent in Australia. The spot rate of the Australian dollar is $.58, while the 1-year forward rate of the Australian dollar exhibits a discount of 2 percent. Assume that as covered interest arbitrage occurred this morning, the interest rates were not affected, the spot rate of the Australian dollar was not affected, but the forward rate of the Australian dollar was affected. Consequently interest rate parity now exists. Explain the forces that caused the forward rate of the Australian dollar to change by completing this sentence:
The ___ [Australian or U.S.?] investors could benefit from engaging in covered interest arbitrage; their arbitrage would involve ___ [buying or selling?] Australian dollars forward, which would cause the forward rate of the Australian dollar to ___ [increase or decrease?].