Assume the following information: One-year interest rate in New Zealand 5 percen

Question

Assume the following information:

One-year interest rate in New Zealand

5 percent

One-year interest rate in U.S

12 percent

Spot rate NZ$

$0.60

Forward rate NZ$

$0.54

initial investment of $10,000,000 (US (NZ) dollars for US (NZ) investor

Is covered interest rate possible for US investors? New Zealand investors? Explain why covered interest rate arbitrage is or is not feasible.

Assume the following:

You can buy a euro for 14 pesos.

The bank will pay you 13 pesos for a euro.

You can buy a U.S. dollar for .9 euros.

The bank will pay you .8 Euros for a U.S. dollar.

You can buy a U.S. dollar for 10 pesos.

The bank will pay you 9 pesos for a U.S. dollar.

You have $1,000.

Can you use triangular arbitrage to generate a profit? If so, explain the order of the transactions that you would execute, and the profit that you would earn. If you cannot earn a profit from triangular arbitrage, explain why.

One-year interest rate in New Zealand

5 percent

One-year interest rate in U.S

12 percent

Spot rate NZ$

$0.60

Forward rate NZ$

$0.54

initial investment of $10,000,000 (US (NZ) dollars for US (NZ) investor

Explanation / Answer

NZ 1 Year Rate = RNZ = 5% and US 1 Year Rate = RUS = 12%;

Spot Rate 1 NZD = 0.60 USD and Forward Rate 1NZD = 0.54 USD

As per the covered interest parity, the forward rate should = 0.60 * (1+12%)/(1+5%) = 0.64 i.e USD should depreciate. In this case, we see that forward rate is 0.54 hence a NZD investor can benefit by investing in USD and locking in a higher value forward rate today than warranted by the current forward rate as below:

NZD Investor Perspective : for covered interest arbitrage, the investor can do following:

Part II : Let us calculate the cross currency rates for USD and compare to direct quote:

1USD can be purchased for 10 and sold for 9 Pesos

If however, we use the indirect route, we can purchase 0.8 Euro for 1 USD, and then get 13 Pesos for 0.8 Euro which will be give us 10.4 Pesos.

Thus we can use this difference and make arbitrage profit as below:

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