Using Covered Interest Arbitrage

Zuber, Inc., is a U.S.-based MNC that has been aggressively pursuing business in Eastern Europe since the Iron Curtain was lifted in 1989. Poland has allowed its currency’s value to be market determined. The spot rate of the Polish zloty is $.40. Poland also has begun to allow investments by foreign investors as a method of attracting funds to help build its economy. Its interest rate on 1-year securities issued by the federal government is 14 percent, which is substantially higher than the 9 percent rate currently offered on 1- year U.S. Treasury securities.

A local bank has begun to create a forward market for the zloty. This bank was recently privatized and has been trying to make a name for itself in international busi- ness. The bank has quoted a 1-year forward rate of $.39 for the zloty. As an employee in Zuber’s international money market division, you have been asked to assess the possibil- ity of investing short-term funds in Poland. You are in charge of investing $10 million over the next year. Your objective is to earn the highest return possible while maintain- ing safety (since the firm will need the funds next year).

While the exchange rate has just become market determined, there is a high probabil- ity that the zloty’s value will be volatile for several years as it seeks its true equilibrium value. The expected value of the zloty in 1 year is $.40, but there is a high degree of uncertainty about this. The actual value in 1 year may be as much as 40 percent above or below this expected value.

a. Would you be willing to invest the funds in Poland without covering your position? Explain.

b. Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage?

c. What risks are involved in using covered interest arbitrage here?

d. If you had to choose between investing your funds in U.S. Treasury bills at 9 percent or using covered interest arbitrage, what would be your choice? Defend your answer.