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Provo Co. has $15 million that it will not need until 1 year from now. It can invest the funds in U.S. dollar-denominated securities and earn 6 percent or in New Zealand dollars (NZ$) at 11 percent. It has no other cash flows in New Zealand dollars. Assume that interest rate parity holds, so the 1-year forward rate of the NZ$ exhibits a discount in this case. Provo expects that the spot rate of the NZ$ will depreciate but not as much as suggested by the 1-year forward rate of the NZ$.

a. Should Provo consider investing in NZ$ and simultaneously selling NZ$ 1 year forward to cover its position? Explain.

b. If Provo invests in NZ$ without covering this position, is the effective yield expected to be above, below, or equal to the U.S. interest rate of 6 percent? Is the effective yield expected to be above, below, or equal to the New Zealand interest rate of 11 percent?

c. Explain the implications if Provo invests in NZ$ without covering its position and the future spot rate of the NZ$ in 1 year turns out to be lower than today's 1-year forward rate on the NZ$.

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  • Category:- Statistics and Probability
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