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Chapter 21

Q. 21.FSE.17

Provo Co. has $15 million that it will not need until one year from now. It can invest the funds in U.S. dollar–denominated securities and earn 6 percent or in New Zealand dollars (NZ$) at 11 percent. It has no other cash flows in New Zealand dollars. Assume that interest rate parity holds, so the one-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 one-year forward rate of the NZ$.
a. Should Provo consider investing in NZ$ and simultaneously selling NZ$ one 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 one year turns out to be lower than today’s one-year forward rate on the NZ$.

Step-by-Step

Verified Solution

a. Provo should not consider investing in NZ$ and simultaneously selling NZ$ one year forward since the effective yield would be 6 percent, the same as the yield in the United States.
b. If Provo invests in NZ$, its yield is expected to exceed the U.S. interest rate but be less than the NZ$ interest rate.
c. If the NZ$ spot rate in one year is lower than today’s forward rate, the effective yield will be lower than the U.S. interest rate of 6 percent.