Question

Interest rates in Mexico are 3% and in the United States they are currently 0.025%. The MXN/USD spot rate is 0.076. You are offered a 12-month forward rate of .08.

A) show whether the forward contract is overvalued or undervalued.

B) which currency should you borrow and why ?

C) what is the percentage return from engaging in Covered Interest Arbitrage ?

Answer 1

a.

Showing whether the forward contract is undervalued or overvalued:

Formula to calculate forward contract:

Substituting Equation with 0.076 for spot rate, 3% or 0.03 for foreign interest rate and 0.025% or 0.00025 for domestic interest rate to calculate the forward contract.

b.

An individual should borrow the currency of Country US because interest rate of this country is less than the Country Mexico. Due to the lower interest rate, borrowers need to pay less amount of interest on their borrowed money. Lower interest rates help to the borrowers in various ways such as facilitates large amount of money to fulfill their needs or wants. Therefore, it is better for borrower to borrow the money from Country US.

c.

Calculation of percentage return from engaging in Covered interest arbitrage:

Assuming that the amount invested in Country Mexico is $1,000,000

Amount on maturity is $1,030,000 [($1,000,000)+(3%)]

Amount in terms of currency of Mexico is $1,112,400 [($1,030,000)+ (0.08)]

Hence, the value of forward contract is 0.078.

When the spot rate is greater than the forward contract, then the value of forward contract is undervalued and when the spot price is less than the forward contract, then the value of forward contract is overvalued. Therefore, with the help of above calculations it is to be known that the value of forward contract is greater than the spot price that is why forward contract is overvalued.

Note: In the above calculations, Country Mexico is considered as a foreign country and Country US is considered as a domestic country.