Question

Assume the following information: - Mexican one - year interest rate = 6% - U.S . one- year interest rate = 3% - Peso spot rate = 0.11 $/p - peso forward rate = 0.08 $/p interest rate parity exists, how do you take advantage of this opportunity ? explain please.

Answer 1

IF INTEREST RATE PARITY (IRP) IS FOLLOWED,

(1 + $ RATE) = (FORWARD RATE/SPOT RATE) ( 1+ PESO RATE)

LET'S CHECK,

(1+0.03) = (0.08/0.11)(1+0.06)

(1+0.03) > 0.7709

SO IRP DOES NOT HOLD.

SO WE HAVE TO BOOROW PESO TO CARRY OUT ARBITRAGE OPPORTUNITY

SUPPOSE WE BORROW 1000,000 PESOS

REPAYMENT IN ONE YEAR WILL BE = 1000,000 ( 1+0.06) = 1060,000 PESO

BUY SPOT DOLLAR USING 1000,000 PESO = 1000,000 PESO X $ 0.11 = $110,000

INVEST DOLLAR AT 3%. THE MATURITY VALUE WILL BE = $110,000 (1+0.03) = $113300

SELL $113300 FORWARD IN EXCHANGE FOR ($113300/0.08 PESO) = 1416250 PESO

ARBITRAGE PROFIT = 1416250 PESO - 1000,000 PESO = 416,250 PESO

ANY DOUBTS, FEEL FREE TO ASK