Question

Assume that you have the following information: Spot Rate: Six-month Forward Exchange Rate: One-Year NZD Interest Rate: One-Year GBP Interest Rate: NZD: New Zealand Dollar GBP: Great Britain Pound 1.98 NZD/1 GBP 2.07 NZD/1 GBP 0.63 % annually -0.26 % annually is covered interest arbitrage worthwhile? If so, calculate the profits after six-months, assuming that you have 5,650 NZD. What else might you do to maximize profits if the covered interest arbitrage is worthwhile (explain in words)?

Answer 1

Covered interest arbitrage is a profit making strategy in the international foreign exchange market where the investor tries to make profit on the interest rate differential between two countries by using a forward contract cover to eliminate the exchange rate risk.

In the question, we have been given the following information on two countries - New Zealand and Great Britain [NZD - New Zealand dollar and GBP - Great Britain Pound]

Spot exchange rate - 1 GBP = 1.98 NZD

6 months forward rate - 1 GBP = 2.07 NZD

one year New Zealand interest rate = 0.63% annually

one year Great Britain interest rate = -0.26% annually

money availabe in hand = 5650 NZD

Answer - with the available NZD, investor will buy the GBP at the spot market on day 1 at the spot rate prevailing at 1 GBP = 1.98 NZD. Hence investor would get 2853.54 GBP by selling 5650 NZD. With this pound, investor will invest in Great Britain deposit for 6 months at the rate -0.26% annually

Also, investor will enter into a forward contract to buy NZD after 6 months at the 6 months forward rate of 1 GBP = 2.07 NZD.

So at the end of 6 months, the investor will get return 2846.195 GBP from the deposit. The investor will sell the GBP at the  agreed forward rate.

Hence at 6 months end, investor will get 2846.195 *2.07 = 5891.62 NZD.

Hence investor will get risk free return of 241.62 NZD [5891.62 - 5650] by doing this investment.

To maximize the profits from the covered interest arbitrage, the investor can borrow money in the New Zealand at the interest rate of 0.63% annually and invest that money in Great Britain and do the above arbitrage by hedging the exchange rate in the forward market. By this way, investor can maximize the profit.