Question

Say you are a currency trader. You know from your Bloomberg database terminal that the spot rate is US$0.8545 = NZ$1, NZ Treasury Bills offer a return of 5 percent per anum, US Treasury Bills offer 2 percent per anum, and the one year forward rate is US$0.8224.

NewZealand dollar is domsetic currency.

a) Say you are trying to work out if the current forward rate to see if the markets are in equilibrium, or they are in disequilibrium and you can make profits by trading currencies. What would you conclude? Why?

b) We know the Reserve Bank is increasing domestic interest rates. How will this change your calculations? Why

Answer 1

a. We are given the following data,

Spot Rate => US$0.8545 = NZ$1, NZ bill interest rate = 5%, US bill interest rate = 2%

This means that US$1 = NZ$1.1702

We know that as per covered interest rate parity,

Forward rate = 1.1702 * (1.05/1.02) = 1.2047

i.e. NZ$1 = US$0.8301

We can see the markets are in disequlibrium.

So an arbitrage profit can be made by carrying out the following steps:

1. Borrows US$100,000 at 2% for a one-year period

2. Immediately convert the amount borrowed to NZ$ at the spot rate of .'US$0.8545 = NZ$1'

3. Invest this amount in the 1 year NZ treasury bill at 5%.

4. Simultaneously enter into a one-year forward contract for the purchase of US$102,000.

This is called Covered Interest rate arbitrage.

b. If the reserve bank increases the interest rate, the difference between the forward currency rates and future currency spot rates would widen and create further opportunity for carrying out an covered interest arbitrage.