Question

Suppose that the interest rate on the 6 months Treasury bill is 10% in Lusaka and 12%
newyork and the spot rate is K18.66/$.
(a) How can a Zambian investor undertake uncovered interest arbitrage
(b) ) How can the Zambian investor who has K500, 000 undertake covered interest
arbitrage if the dollar is at three month forward premium of 1% (per year)? How
much would the Zambian investor earn on his foreign investment?

Answer 1

A) Zambian investor can borrow money from Lusaka at 10% and invest it in Newyork at 12%. he can make some arbitrage profit.

B)   we can derive the forward rate from the following formula :-

forward premium = (forward rate - spot rate/spot rate)*100

  forward premium for 6 month = 1*6/12=0.5%

spot rate for 6 month = K18.66/$

0.5%= (forward rate-18.66/18.66)*100

  forward rate = 19.59

the arbitrage profit using k 500,000 is shown below :-

outflow from borrowing money from Lusaka at 10%= k 500,000*(1.10) =5,50,000

inflow from selling of k 500,000 at spot rate of K18.66 = $ 26,795

inflowfrom investing of $ 26,795 @ 12% for six month = 26,795*(1.12) = $ 30,011

$ equivalant amount of K = $ 30,011*19.59 = K 5,87,915

   arbitrage profit = K 5,87,915 - k 5,50,000 = K 37,915