Zuber Inc. Case Study

Would you be willing to invest the funds in this country without covering your position? Explain. It looks like investing in this country could be very profitable because the yield offered would be 14 percent (compared to only 9 percent in the US), but there are a few possible dangers in making an investment in a market that’s not stable yet. The country’s currency has become market-determined, so it’s volatile as it tries to find its equilibrium which means unstable market for now. Another problem is the probability of high inflation as the interest rate is much too high for a stable economy. High inflation rate is connected with the currency depreciation, which leads to prices increase. Furthermore, a risk of a large fluctuation in the value of the currency (40 percent above or below the expected value) exists. There is also the currency risk, which would occur due to unexpected changes in the exchange rate between the Dollar and the local currency. Hence the whole operation seems risky, some coverage should apply.

Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage? The currency risk needs to be covered to avoid exposure and make riskless profit from the forward premium. Covered Interest Arbitrage could mean exchanging dollars for the foreign currency at the spot rate now, investing the currency in the funds and then, after a year, selling this currency for the changed forward rate and get the dollars in return. 10 million USD, would exchange into the foreign currency at the spot rate ($.40) and obtain 25 million units of the foreign currency. At the end of the year, this amount will rise to 28.5 million units of the foreign currency (14% interest rate). This sum can be converted again into USD, but now the forward exchange rate ($.39). After this operation the amount equals 11,115,445 USD, which means that the return is ca 11,15%. Task 3. What risks are involved in using covered interest arbitrage here? The CIA eliminates the currency risk here, but a bunch of others dangers may lead to the failure of the investment: 1. The country’s market is certainly not stable and efficient. The exchange rate has just become market-determined and t will fluctuate for a couple years which means that the situation on the market may change any moment.

The interest rate also says that the inflation in this country is rather high. 2. There is also a risk of receivables, which unlike the currency risk cannot be covered. The local bank was just privatized and doesn’t have experience as an institution. This may lead to the serious issues with capital and liquidity or the bank’s bankruptcy. The bank may simply not fulfill the contract and fail the company. 3. Because the country has just begun to allow foreign investment on the market, it seems that there is no law concerning international transactions or finances. In case of such a big investment it’s necessary for the foreign company to have a law props in order to avoid unsolicited misunderstandings or solve the previously occurred problems. Moreover, there is a possibility that the government will undertake certain unhelpful or even destructive decisions for the foreign investors, such as closing the market for the foreign currency or banning the currency conversion.

If you had to choose between investing your funds in US Treasury bills at 9 percent or using covered interest arbitrage, what would be your choice? Defend your answer. Having calculated the return of the covered interest arbitrage (profit of 11.15%) and the return in case of investing in US (profit of 9%), it turned out that the Eastern European country’s market has a greater potential than the US market when it comes to profiting from interest rates. The difference of 2,5% is pretty significant- it makes up for the sum of 215,445 USD. On the other hand there is no denying that the investment and staying on this market may be risky and imply the possibility of bankruptcy. Unstable market, inexperienced local bank and no laws of the international business are just the examples of the problems therein. Considering both pros and cons, Zuber should invest in that country to gain higher returns with greater risk involved. Even though losses may occur, the possible profits are greater. The main risk has been eliminated by Covered Interest Arbitrage, and the rest of them is not dangerous enough to forfeit the operation.