Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or inve

Question

Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year forward rate of the peso is $.10. If U.S. firms attempt to use covered interest arbitrage, what forces should occur?

A) Does interest arbitrage hold? Is covered interest arbitrage possible?

B) Suppose a typical US investor can borrow $1 million, and a typical Mexican investor can borrow 1 million pesos for arbitrage transactions. If an arbitrage opportunity is possible, decide which investor it favors, and the amount of arbitrage profits that can be gained.

Explanation / Answer

If the US firms attempt to use coverd interest arbitrage, then the spot rate of peso increases and forward rate of peso decreases.

a) Covered interest rate arbitrage is possible when the forward premium does not reflect the interest rate differential between the two countries specified by the interest rate formula.

b) We know that one peso is equal to 0.069 dollar. Borrowing dollars is good for US investor because if dollars are converted to pesos, then he borrowed amount would be $14.5 million instead of one million dollars for the US investor .

Gain = $14.5 million - $1 million = $13.5 million

hence, the gain would be $13.5 million for the US investor.

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