Question

Assume the following information

Current spot rate of New Zealand dollar	=	$0.41
Forecasted spot rate of New Zealand dollar 1 year from now	=	$0.43
One-year forward rate of the New Zealand dollar	=	$0.42
Annual interest rate on New Zealand dollars	=	0.075
Annual interest rate on U.S. dollars	=	.09

Given the information in this question, the return from covered interest arbitrage by U.S. investors with $479,000 to invest is about ________.

Answer 1

Covered Interest Rate Parity:

Covered interest rate parity is based on an non-arbitrage argument. By using spot exchange rate and forward contract, investors should not be able to generate risk-free profit through borrowing and lending at risk-free rates in different countries.

Answer and Explanation:

The investor could realize a profit of $5,374.1463.

The U.S. investors could perform the following sequence of trades:

1) Borrow $ 479,000 at the U.S. interest rate of 0.09 for one year.

2) Convert the fund into NZ dollars at the spot rate of $0.41, which yields 479,000 / 0.41 =   1,168,292.683 NZ dollars.

3) Invest the NZ dollar fund at the NZ interest rate of 0.075 for one year.

4) Enter into a forward contract to sell NZ dollars at $0.42

After one year, the NZ dollar investment will have a total value of:

• 1,168,292.683 * (1 + 0.075) = 1255914.634

Exercise the forward contract and sell the NZ dollars, which yields:

• 1,255,914.634 * 0.42 = 527,484.1463

Pay off the U.S. dollar loan, which requires a total payment of:

• 47,9000 *(1 + 9%) = 522,110

Have a net profit = 527,484.1463 – 522,110 = 5,374.1463