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Zuber, Inc.: Assessment of Prevailing Spot and Forward Rates by The Sports Exports Company

The document discusses covered interest arbitrage involving converting dollars to a foreign currency, investing the currency in the country's Treasury securities, and entering a forward contract to exchange the currency back to dollars in one year. While this strategy could yield 11.15% versus 9% in the U.S., it carries significant risks as the country only recently allowed foreign investment and transactions, including the potential for default on securities, failure of banks to honor contracts, and restrictions on currency conversion. Given the higher potential returns but also higher risks, the scenario could lead to an interesting class discussion on evaluating such an investment opportunity.

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100 views2 pages

Zuber, Inc.: Assessment of Prevailing Spot and Forward Rates by The Sports Exports Company

The document discusses covered interest arbitrage involving converting dollars to a foreign currency, investing the currency in the country's Treasury securities, and entering a forward contract to exchange the currency back to dollars in one year. While this strategy could yield 11.15% versus 9% in the U.S., it carries significant risks as the country only recently allowed foreign investment and transactions, including the potential for default on securities, failure of banks to honor contracts, and restrictions on currency conversion. Given the higher potential returns but also higher risks, the scenario could lead to an interesting class discussion on evaluating such an investment opportunity.

Uploaded by

abhirthete
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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Zuber, Inc.

a. The expected value of the yield on investing funds in this country would be 14 percent, versus
only 9 percent in the U.S.  However, there is much uncertainty about the foreign yield.  If the
currency depreciates by a large amount, it will wipe out some of the principal invested.  Given that
Zuber did not want to target these funds for a speculative purpose, it would not be wise to invest
these funds in the country without covering.

b. Covered interest arbitrage would involve exchanging dollars for the currency today, investing the
currency in the country’s Treasury securities, and negotiating a forward contract to sell the
currency in one year in exchange for dollars.

Given that $10 million is available, this amount would be converted into 25 million units of the
foreign currency, which would accumulate to 28.5 million units (at 14 percent) by the end of the
year, and be converted into $11,115,000 at the time (based on a forward rate of $.39).   This
reflects a return of 11.15 percent.

c. The risks of covered interest arbitrage are as follows:

· The Treasury of the country could default on its securities issued.

· The bank may not fulfill its obligation on the forward contract (the bank was just recently
privatized and does not have a track record as a privatized institution).

· The government could restrict funds from being converted into dollars.  (Since the country has
only allowed foreign investments recently, it does not have a track record.   There is some
uncertainty about its future laws on international finance.)

d. While covered interest arbitrage would be expected to achieve a yield of 11.15 percent (versus
only 9 percent in the U.S.), the risks are significant, especially considering that the country is still
experimenting with cross-border transactions.  Since some students will probably suggest going
for the higher returns, this question may allow for an interesting class discussion.

Small Business Dilemma


Assessment of Prevailing Spot and Forward Rates by the Sports Exports Company

1. Do you think Jim will be able to find a bank that provides him with a more favorable spot rate
than his local bank? Explain.

ANSWER: The quoted spot rate for British pounds will typically be similar among banks at a
given point in time, because locational arbitrage might be possible if there were significant
differences. It is possible that some banks that rarely provide the foreign exchange services quote
a less favorable exchange rate, and locational arbitrage will not necessarily correct this if these
banks have a large spread between the bid and the ask quotes. Therefore, it may be worthwhile
for Jim to call other banks to obtain quotes, but Jim will likely find that he cannot obtain a much
better rate than what his local bank provides.

90
Chapter 7: International Arbitrage and Interest Rate Parity 91

2. Do you think that Jim’s bank is likely to provide more reasonable quotations for the spot rate of
the British pound if it is the only bank in town that provides foreign exchange services? Explain.

ANSWER: The bank is likely to provide more reasonable quotations for the spot rate of the
British pound if there are many banks in town that provide foreign exchange services. In this case,
there is more competition, and a local bank is more likely to lose business if its quotations are not
reasonable.

3. Jim is considering using a forward contract to hedge the anticipated receivables in pounds next
month. His local bank quoted him a spot rate of $1.65 and a one-month forward rate of $1.6435.
Before Jim decides to sell pounds one month forward, he wants to be sure that the forward rate is
reasonable, given the prevailing spot rate. A one-month Treasury security in the United States
currently offers a yield (not annualized) of 1 percent, while a one-month Treasury security in the
United Kingdom offers a yield of 1.4 percent. Do you believe that the one-month forward rate is
reasonable given the spot rate of $1.65?

ANSWER: Yes. According to interest rate parity, the forward rate premium should be based on
the differential between interest rates:

p = [(1 + .01)/(1 + .014)] – 1


= [.996055] – 1
= –.0039448

The actual premium is:

p = (F – S)/S
= ($1.6435 – $1.65)/$1.65
= –.003939

The actual premium is very close to what the premium should be according to interest rate parity.

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