Question

Assume the following information:

One-year interest rate in New Zealand	5 percent
One-year interest rate in U.S	12 percent
Spot rate NZ$	$0.60
Forward rate NZ$	$0.54
initial investment of $10,000,000 (US (NZ) dollars for US (NZ) investor

Is covered interest rate possible for US investors? New Zealand investors? Explain why covered interest rate arbitrage is or is not feasible.

Answer 1

Interest rate differential = 5-12 = -7%

Forward discount rate= (0.54-0.60)/0.60 = -10%

Since there is a difference between Interest rate differential and Forward discount rate between the two countries, covered interest rate aribitrage is possible.

Borrow curency with lower interest rate and invest in higher interest rate currency.

covered interest rate possible for US investors.

Covered interest rate will be profitable because the market forward rates is not equal to the FR as implied by interest rate parity and an investor can gain through investing in higher yield currency.

At T=0:

1. Borrow NZ$ (10,000,000/0.60) = 16,666,666.67 @ 5% per annum
2. Covert it into $ at spot rate = $10,000,000 and invest for 1 year @ 12% p.a.

At T=1

1. Receive from $ investment = 10,000,000*(1+0.12) = $11,200,000.00
2. Covert it into NZ$ using rate of $0.54/NZ$: NZ$ 20,740,740.74
3. Repay NS$ loan = 16,666,666.67*(1+0.05) = 17,500,000.00

Net benefit = NZ$ 3,240,740.74