Question

Assume the following information:

     Spot rate of Mexican peso                    = $0.1

     180‑day forward rate of Mexican peso = $0.098

     180‑day Mexican interest rate               = 6%

     180‑day U.S. interest rate                    = 5%

Given this information, is covered interest arbitrage worth­while for Mexican investors who have pesos to invest? Assume you have MXP1,000,000 as your initial investment. Explain your solution.

Answer 1

IRPT forward Rate = Spot Rate * ( 1 + Hi ) / ( 1 + Fi))

Hi = Int Rate in US

Fi = Int Rate in Mexico

IRPT forward Rate = Spot Rate * ( 1 + Hi ) / ( 1 + Fi))

= 0.1 * ( 1 + 0.025 ) / ( 1 + 0.03)

= 0.1 * 1.025 / 1.03

= 0.0995

Actual Fwd rate is $ 0.098

As IRPT Fwd rate and Actual Fwd Rate are not same, covered int arbitrage is possible.

COvered Int Arbitrage:

Take a Loan of MXP 1 Million

Convert into USD using spot Rate

Amount in USD = 1000000 * 0.1

= USD 100000

Invest In US for 180 days and realize the maturity

Maturity Value = USD 100000 ( 1 + 0.025)

= USD 102500

COnvert into MXP using fwd Rate

AMount in MXP = 102500 / 0.098

= 1045918.37

Payoff Loan along with Int

= MXP 1000000 ( 1 +0.03 )

= MXP 1030000

Net profit in MXP = 1045918.37 - 1030000

= MXP 15918.37

Profit in USD = 15918.37 * 0.098

= USD 1560

Pls do rate, if the answer is correct and comment, if any further assistance is required