IRP, PPP, and Speculating in Currency Derivatives.
The U.S. three-month interest rate (unannualized) is 1%. The Australian three-month interest rate (unannualized) is 2%. Assume interest rate parity exists. The expected inflation over this period is 4% in the U.S. and 3% in Australia. A call option with a three-month expiration date on Australian dollars is available for a premium of $.02 and a strike price of $.86. The spot rate of the Australian dollar is $.89. Assume that you believe in purchasing power parity.
Determine the dollar amount of your profit or loss from buying a call option contract specifying $70,000 Australian dollars. Show all work.