Question

Covered Interest Arbitrage in Both Directions.

1) The one‑year interest rate in New Zealand is 4 percent. The one‑year U.S. interest rate is 5.5 percent. The spot rate of the New Zealand dollar (NZ$) is $.60. The forward rate of the New Zealand dollar is $.615. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.

Answer 1

a)Calculation of yield from covered interest arbitrage:

For the calculation of yield form covered interest arbritage by U.S. investor,assumed investment of $100,000

NZ$ equivalent investment=$100,000/$0.60=$166,667

Investment value at the end of year 1=$166,667(1.04)=NZ$173,333

US$ equivalent Value=NZ$173,333*$0.615=$106,600

Yield(%)=($106,600-$100,000/$100,000)*100

=6.6%

Covered interest arbitrage is feasible for U.S. investors as yield(6.6%) is higher than the U.S. interest rate of 5.5%

For the calculation of yield form covered interest arbritage by New Zealand investor,assumed investment of NZ$100,000

US$ equivalent investment=NZ$100,000*$0.60=$60,000

Investment value at the end of year 1=$60,000*(1.055)=$63,300

NZ$ equivalent value=$63,300/0.615=NZ$102,927

Yeild(%)=[(NZ$102,927-NZ$100,000)/NZ$100,000]*100

=2.93%

Covered interest arbitrage is not feasible for the New Zealand investors as Yield(2.93%) is lower than one‑year interest rate in New Zealand(4%)