Answer the following questions regarding speculating with currency futures. Assu

Question

Answer the following questions regarding speculating with currency futures. Assume that a March futures contract on the Mexican peso was available in January for $0.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $0.092 per peso. a. How could speculators capitalize on this situation, assuming zero transaction costs? (10 points) b. How would such speculative activity affect the difference between the forward contract price and the futures price?

Explanation / Answer

a) As the futures price for the Peso is less than the forward price for Peso, it would be profitable to buy Peso futures and sell those Pesos forward. The profit would then be $0.002 per Peso that is so traded. b) As more and more arbitrageurs would adopt the strategy there would be increase in demand for Peso in futures market and increase in supply of Peso in the forward market. This will lead to the increase in the price of Peso in the future market and decrease in its price in the forward market. As such transactions increase, the gap between the prices keeps on narrowing till it becomes 0. At this stage there would be no further arbitrage possibility.

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