Question

Suppose 1-year interest rates are 11% in South Africa and 4% in the United States. The...

Suppose 1-year interest rates are 11% in South Africa and 4% in the United States. The current spot rate of the South African Rand (ZAR) is USD 0.12. Forward contracts on ZAR are available with a 7% discount. Question: Can a US-based investor successfully use Covered Interest Arbitrage in South Africa?

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Answer #1

Spot $/ZAR = 0.12

1 Year Forward $/ZAR = 0.12*(1-0.07) = 0.1116

As per Interest Rate Parity,

Theoretical Forward Rate $/ZAR = Spot $/ZAR*(1+Interest Rate on $)/(1+Interest Rate on ZAR)

= 0.12*[1+0.04]/[1+0.11]

= 0.1124

Actual Forward Rate < Theoretical Forward Rate

As the Rates are different, Interest Rate Parity(IRP) DOES NOT exist.

As the Rates are different, there is a Covered Interest Arbitrage Opportunity.

Actual Forward Rate of ZAR is Undervalued

To make an Arbitrage Gain, Sell ZAR in Spot and Buy in Forward

It ia ASSUMED that, US based Investor will have $. And in this case, ZAR needs to be sold and $ needs to be Bought. Therefore, US based Investor CANNOT use Covered Interest Arbitrage

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