Question

Assume the following information:

♦ Mexican one-year interest rate = 9 %

♦ U.S. one-year interest rate = 4 %

♦ Peso spot rate = 0.11 $/p

♦ Peso forward rate = 0.08 $/p

If interest rate parity exists, how much money you can make per each unit. For example, if one can make $0.0303 per peso

Answer 1

Solution:

♦ Mexican one-year interest rate = 9 %

♦ U.S. one-year interest rate = 4 %

♦ Peso spot rate = 0.11 $/p

♦ Peso forward rate = 0.08 $/p

As per interest rate parity theory:

(Forward Rate $/p) / (Spot Rate $/p) = (1+Interest rate$) / (1+ Interest rate p)

(Forward Rate $/p) / (0.11 $/p) = (1.04) / (1.09)

Hence, Forward Rate $/p = 0.1049 $/p

Since, Forward rate as per interest parity is 0.1049 $/p but actually in the market is 0.11 $/p.

Hence, we can make 0.0051 $/p (i.e. 0.11 - 0.1049), by selling (short) the forward contract as these are overpriced.

(Please provide your valuable feedback and feel free to ask in case of any query. I will be grateful if I can help you. Thank You)

, how much money you can make per each unit. For example, if one can make $0.0303 per peso