Question

Suppose that the current spot exchange rate between the US dollar and NZ dollar is $.70/NZ$ and the 1-year forward rate is $.695. The one year interest rates are 1% for the USD and 3% for the NZ$. What is the payoff if a US MNC conducts covered interest arbitrage, for a $1,000,000 starting amount?

1,022,643

$1,010,000

$985,857

$1,000,540

Answer 1

Convert $1,000,000 into NZ$ at spot rate and get 1,000,000/0.70 = NZ$1,428,571.43

Invest for 1 year and get NZ$1,428,571.43*(1+3%) = NZ$1,471,428.57

Convert back into USD and get NZ$1,471,428.57*0.695 = $1,022,642.86 i.e. $1,022,643

Repay loan 1,000,000*(1+1%) = $1,010,000

Arbitrage gain = $12,642.86

Hence, the answer for payoff is

$1,022,643