Question

a) The following information is given to an Australian hedge fund. The fund currently has A$10m sitting in a current account, thus is considering to deploy this amount of money in short term. Would the fund be able to make profits from covered interest arbitrage?

	Bid quote	Ask quote
NZ$ Spot	A$0.9216	A$0.9286
One-year NZ$ Forward	A$0.9304	A$0.9374
	Deposit rate	Loan rate
In Australia (on A$)	1%	2.5%
In New Zealand (on NZ$)	1.5%	2.5%

b) Would the hedge fund still benefit from this arbitrage if it has to borrow in Australia to make investment instead of using its own fund?

Answer 1

a) To undertake the covered interest arbitrage, the firm would need to perform the following steps:

1. Convert A$10m to NZ$. Since it is looking to buy NZ$, it would be able to convert at the spot ask quote i.e A$0.9286/NZ$. It will receive 10m/0.9286 = NZ$10,768,899.4.

2. The fund would then invest this amount in New Zealand at 1.5% for one year and to cover its trade, it would enter into a one-year forward contract to exchange NZ$ for A$ at A$0.9304/NZ$ (the bid quote would apply as it is looking to sell NZ$).

3. At the end of one year, the fund would receive 10,768,899.4 * 1.015 = NZ$10,930,432.9. On converting this into A$ it would receive 10,930,432.9*0.9304 = A$10,169,674.8.

4. The interest that the fund has foregone by not investing this amount in Australia is 10m*0.01 = AS$100,000.

5. Profit from arbitrage = Amount redeemed - amount invested- interest foregone

= 10,169,674.8 - 10,000,000 - 100,000

= AS$ 69,674.8

Thus, the fund would be able to make a profit of AS$ 69,674.8 from covered interest arbitrage.

b) In case the fund had borrowed instead of using its own funds, it would have paid interest at 2.5%. The amount of interest at AS$10m for one year would be 10m*0.025 = AS$250,000.

In this case the arbitrage profit would be calculated as follows:

Amount redeemed - amount invested- interest paid

10,169,674.8 - 10,000,000 - 250,000

= - AS$ 80,325.2

Thus in this case the fund would have actually incurred a loss of AS$ 80,325.2 .