Question

Assume the following information for question 1:

	United States	Mexico
Nominal One Year Interest Rate	3%	6%
Expected One Year Inflation Rate	2%	3%
Spot Rate	----	$0.055
One Year Forward Rate	----	$0.050

1.) Does interest rate parity (IRP) hold? Given your answer, does an opportunity for covered interest arbitrage exist for investors residing in either the U.S. or in Mexico? If covered interest arbitrage is possible, explain for whom and then calculate the currency profit (USD or peso) and expected yield (percentage return) on a 1,000,000 ___________ investment (1,000,000 USD or 1,000,000 Mexican pesos).

2.) Assume that the current spot rate for the Canadian dollar is 0.78 USD per CAD. How will this rate adjust according to Purchasing Power Parity (PPP) if Canada experiences a 3 percent inflation rate over the next 12 months while the U.S. experiences a 5 percent inflation rate over the same time period? Hint: calculate the expected spot rate for the CAD one year from now and explain how the spot rate is expected to change.

Answer 1

Solution 1
Nominal One Year Interest Rate US	3%	quot
Nominal One Year Interest Rate Mexico	6%	base
Spot Rate USD per peso	$0.055
1 year forward USD per peso	$0.050
IRP (interest rate parity) is a wide know theory based on a relationship between the interest rates of two given currencies and the spot and forward exchange rates between the currencies
1 year forward rate as per IRP (interest rate parity)
Formula	Spot rate*	1+R(quot)
		1+R(base)
	$0.055*	1+3%		or		0.053
		1+6%
As the 1 year forward USD per peso is $0.053 as against $0.050 we can say that there is an opportunity for covered interest arbitrage exist
As USD is costly in future ($0.050 vs $0.053) hence we will sell USD in forward and purchase peso in forward
Covered interest arbitrage
1. Borrow in Peso @ 6%	1000000
2. Convert in USD using current spot rate (0.055)	55000	(1000000*0.055)
3. Invests these proceeds in a deposit denominated in USD @ 3% pa
	56650	(55000*1.03)
4. Simultaneously enters into a one-year forward contract for the purchase of 1060000 Peso
5. After on year convert USD in Peso	1133000	(56650/0.05)
6. Net Benefit:
Procced in Peso after 1 year	1133000
Loan repayment	-1000000
Interest @6%	-60000	(1000000*6%)
Net Benefit	73000
Yield %	7.30%	(73000/1000000)
Solution 2
Inflation One Year Interest Rate US	5%	quot
Inflation One Year Interest Rate Canada	3%	base
Spot Rate USD per CAD	0.78
expected spot rate for the CAD one year from now according to Purchasing Power Parity (PPP)
Formula	Spot rate*	1+I(quot)
		1+I(base)
	0.78*	1+5%		or		0.795
		1+3%
Purchasing power parity theory assumes that differences in inflation rates between two currencies induce readjustment of exchange rate.
As Inflation is higher in US as against Canada hence USD will trade at a lower value or for 1 CAD in future we will get more USD.