Using Covered Interest Arbitrage
Crayson Co. is a U.S.-based MNC that has $5 million in cash available. It will not need the funds for one quarter. Crayson notices that the quarterly bank deposit interest rate in the country of Zynland is 2% (not annualized) versus only 1% in the United States. Also, there is no credit risk because the bank deposit is back fully by the Zynland Government. The currency in Minland (called the Zyn) has been tied to the value of the euro (2 zyn = 1 euro) for the last eight years. The quarterly interest rate in the eurozone is 1 percent. The spot rate of the euro is presently $1, while the quarterly forward rate of the euro is $1. The zyn is presently valued at $.50, so that 2 zyn are presently equal to $1. Because the zyn is tied to the euro, it fluctuates against the dollar over time in the same manner that the euro fluctuates against the dollar over time.
a) Explain how Crayson Co. could possibly earn a higher return on its funds by a form of covered interest arbitrage in which it invests in the zyn and covers its position with a forward sale in euros. What would be its expected return over the quarter if the zyn remains tied to the euro?
b) Explain the risk to Crayson Co. of engaging in the form of covered interest arbitrage described in the previous question.