US and Australia Interest Rate Differential

Have you noticed a the current trend with interest rates? US interest rates are tumbling fast, while the Australian interest rates have been inching up. How can you profit from this trend? Below is a prospective strategy using currency warrants from Macquarie Research:

As the differential between interest rates in the Untied States and Australia continue to increase, the pressure on the value of the USD continues to heighten. In today’s environment we are seeing the U.S. Federal Reserve continue to drop rates to stimulate the economy from recession while the Reserve Bank of Australia tries to reduce inflation by raising rates. Interest Rate Parity theory states that the future value of one currency to another is a function of relative interest rates, this may be a perfect opportunity to benefit from this fundamental theory if these trends continue.

If you believe that in the near term the differential between interest rates in the U.S and Australia are going to continue to increase and you subscribe to the theory of Interest Rate Parity then this is an example of how to profit from this scenario by using Macquarie Currency Warrants. Worked examples of how Currency Warrants could be used to profit from the current macro-economic environment.

Interest Rate Parity Theory:

Current Interest Rate Differential: 7.25% - 2.25 = 5%
Amount Invested: $100,000
Return after 3 Months in AUD: 100,000 * (1.0725)^0.25 = $101,765.21
Return after 3 Months in USD: 100,000 * (1.0225)^0.25 = $100,557.82
Difference in Return: $101,765.21 – $100,557.82 = $1,207.39
Percentage Difference = $1,207.39 / $100,000 = 1.207%

Using Interest Rate Parity we would expect that in 90 days the AUD will appreciate by 1.207%.

Over the past three months the interest rate differential between the U.S and Australia has increased from 2.5% to 5%, if we predict that the trend will continue and that the differential increases to say 7.5% (1% vs. 8.5%) then we would expect that the AUD would appreciate by 1.81%.

Using Currency Warrants:

Current Exchange Rate: 1USD to 0.92 AUD
Future predicted exchange rate as per Interest Rate Parity: 0.92 * 1.0181 = 0.9367

If we used the warrant AXUWMG June 2008 $0.85 Currency Warrant listing tomorrow then this would be the payoff at maturity:

Tomorrow’s price if exchange rate is $0.92: $0.81
Price at maturity if exchange rate is $0.9367: (Exchange rate – Strike) * (Multiplier/Exchange Rate)
(0.9367 – 0.85) * (10 / 0.9367) = $0.925

Based on information available to MBL as at 27/03/2008. Macquarie Instalments are issued by Macquarie Bank ABN 008 583 542 Completion Payment for IMC/IMD reset 19/05/2008; for IMF/IMG reset 17/11/2008. This document is general and does not take into account the specific circumstances or needs of any particular person who may read it. Potential investors are advised to seek independent professional advice on the implications of investing in Macquarie Instalment*