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The interest rate offered on (Norwegian) Krone is 0
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The interest rate offered on (Norwegian) Krone is 0.85%, which is quite low. Given the current Covid-19 pandemic, you expect the Krone to depreciate by 0.3%. For the international Fisher effect (IFE) to hold between Norway and Australia, the Australian interest rate should be ____. A. 0.55% B. 0.85% C. 1.15% D. 1.85% E. 2.00%
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Covered Interest Arbitrage. Assume the following information: Spot rate of Canadian dollar = $.80 90 day forward rate of Canadian dollar $.79 90-day Canadian interest rate = 2.5% 90 day U.S. Interest rate
Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor in- vests Sl million.) What market forces would occur to eliminate any further possibilities of covered in- terest arbitrage?
Expert Solution
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The correct answer is 1.15%
When the currency depreciate the interest rate will increase as the depreciation in the currency can increase the inflation so the central bank will increase the interest rate so that the effect will be neutral.
Australian dollar = 0.85% + 0.30%
= 1.15%
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Investment = $1 million
Canadian Dollar (CAD) Spot Rate (S0) = $0.80
CAD 90 days forward rate (F1) = $0.79
Canadian 90-day interest rate (RCAD) = 4%
US 90-day interest rate (RUS) = 2.5%
Steps
1. Convert $ 1 million to CAD at $0.80/CAD. The amount that investor gets is CAD 1.25 million.
2. Invest CAD 1.25 million at 4% for 90 days and simultaneously enter into a forward contract to exchange CAD for USD at the rate of $0.79/CAD.
3. Total amount including interest after 90 days = 1.25*1.04 = CAD 1.3 million.
4. Fulfill forward contract by exchanging CAD 1.3 million at $0.79/CAD to get $1.027 million.
Arbitrage Profit
Difference between invested amount and final amount = $1.027 - $1 = $27000
Interest foregone by not investing in US at 2.5% = $1 million * 0.025 = $25000
Arbitrage profit = $27000-$25000 = $2000
Arbitrage yield = (2000/1000000)*100 = 0.2 %
As the market capitalizes on the arbitrage opportunity there would be:
1. Downward pressure on the spot rate
2. Upward pressure on the 90-day forward rate
Once the difference between the spot and forward rate is approximately equal to the interest rate differential, covered interest arbitrage would not be feasible.
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