Question

Covered Interest Arbitrage. Assume the following information:

Spot rate of Mexican peso	= $.100
180‑day forward rate of Mexican peso	= $0.097
180‑day Mexican interest rate	0.06
180‑day U.S. interest rate	0.065

Suppose an initial investment of 1,000,000 pesos. Given this information, Mexican Investors would generate a yield of ???

Answer 1

Concept of Covered Interest Rate Arbiterage

Step 1: An Invester will Borrow 'X' pesos at Pesos's domestic borrowing rate

Step2: Convert these 'X' pesos to USD at the Spot Rate resulting in 'Y' USD

Step3: Book a forward contract to convert USD to Pesos at the current forward rate

Step3: Invest 'Y' USD at USD's rate

Step4: At the end of tenure, Convert [ 'Y' USD + Interest in USD ] to Pesos at the booked forward rate at the beginning

Solution:

Step1:

1,000,000 pesos to be borrowed at 6% (180day Mexican Interest Rate)

Borrowing Cost = 1,000,000 x 6% = 60,000 pesos

Total Repayment at the end = 1,000,000 + 60,000 = 1,060,000 pesos

Step2:

Covert pesos to USD = Pesos x Pesos/USD spot rate

USD Amount = 1,000,000 x 0.1 = 100,000 USD

Booking a forward contract to convert USD to Pesos at the given forward rate i.e. $0.097 USD

Step3:

Interest Received for Amount invested in USD = 100,000 x 6.5%

Interest Recevied (in USD) = 6,500 USD

Amount Received in USD at the end = 100,000 + 6,500 = 106,500 USD

Step4:

Converting this amount received in USD to Pesos at the forward rate booked i.e. $0.097

Amount Received in Pesos = USD 106,500 / USD 0.097

Amount Received in Pesos = 1,070,024 Pesos

Less: Amount Payable in Pesos = 1,060,000 Pesos ...... Calculated in Step 1

Net Profit = 1,070,024 - 1,060,000 = 10,024 Pesos

Yield in Pesos = Net Profit / Initial Investment

Yield in Pesos = 10,024 / 1,000,000

Yield in Pesos = 1.0024% ....... Answer