40 41 COVERED INTEREST ARBITRAGE Spot rate of Monrovian bibbles 180 day forward

ID: 1171611 • Letter: 4

Question

40 41 COVERED INTEREST ARBITRAGE Spot rate of Monrovian bibbles 180 day forward rate of Monrovian bibble 180 day Monrovian interest rate 180 day US interest rate $0.098 Given this information, and using one million Monrovian bibbles as the initial investment, is covered interest arbitrage worthwhile for Monrovian investors who have bibbles to invest? Explain your answer Show each step of your CIA strategy, then discuss the results Convert 1mm bibbles to USD invest dollars for 180 days at 5% (don't forget to account for 180360 days) Convert USD to bibbles at the forward rate (you have a contract to buy bibbles at the forward rate annualized yield for your 180 day investment 0.50 0.50 USD 50 51 52 0.50 0.50 0.50

Explanation / Answer

1 million bibles to USD (1,000,000 * 0.100)

100000

Value after investing for 180 year at 5% ($100,00 + $100000 * 5% * 180/360)

102500

Value in bibles after 180 days ($102,500/0.098)

1045918

Annualized yield for 180 day investment *

9.18%

Annualized yield:

Total bibles invested in USD = 1,000,000

Interest earned by investing in USD = 1045918 – 1000000 = 45,918

45,918 = 1,000,000 * R *180/360

R = 9.18

Yes, it is worthwhile to the Monrovian investor to use covered interest arbitrage. Monrovian would able to earn 9.18% interest rate which is higher than domestic interest rate (6%)

ih (interest rate in home country)

if (interest rate in foreign country)

11%

S (spot exchange rate)

$ 0.50

P (premium or discount)

-0.04505

P = (1 + .06) / (1 + .11) – 1 = -0.04505

Ratio of Forward to Spot = 0.50 / 0.46 = 1.0869

Ratio of Returns = (1+.11) / (1+.06) = 1.04716

As two values are not equal, therefore interest rate parity does not exists.