Question

Vincey, Inc., is a U.S.-based MNC that has been aggressively pursuing business in Eastern Europe since the Iron Curtain was lifted in 1989. Poland has allowed its currency’s value to be market determined. The spot rate of the Polish zloty is $.40. Poland also has begun to allow investments by foreign investors, as a method of attracting funds to help build its economy. Its interest rate on one-year securities issued by the federal government is 14 percent, which is substantially higher than the 9 percent rate currently offered on one-year U.S. Treasury securities. A local bank has begun to create a forward market for the zloty. This bank was recently privatized and has been trying to make a name for itself in international business. The

bank has quoted a one-year forward rate of $.39 for the zloty. As an employee in Vincey’s international money market division, you have been asked to assess the possibility of investing short-term funds in Poland. You are in charge of investing $10 million over the next year. Your objective is to earn the highest return possible while maintaining safety (since the fi rm will need the funds next year). Since the exchange rate has just become market determined, there is a high probability that the zloty’s value will be very volatile for several years as it seeks its true equilibrium value. The expected value of the zloty in one year is $.40, but there is a high degree of uncertainty about this. The actual value in one year may be as much as 40 percent above or below this expected value.

a. Would you be willing to invest the funds in Poland without covering your position? Explain.

b. Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage?

c. What risks are involved in using covered interest arbitrage here?

d. If you had to choose between investing your funds in U.S. Treasury bills at 9 percent or using covered interest arbitrage, what would be your choice? Defend your answer.

Answer 1

a. Yes as Arbitrage profit is $ 1.4 M

b. By CIA process ,Arbitrage gain is $ 0.2150 M

c. Since the Forward rate is less than Expected Spot rate , Arbitrage gain in Covered Interest arbitrage is not more than No cover.

d. Investing funds in US as Arbitrage gain of 0.9 M is more than 0.2150 in CIA.