Question

2. Covered Interest Arbitrage. Assume the following information:

Spot rate of Mexican peso = $.100

180day forward rate of Mexican peso = $.099

180day Mexican interest rate = 6%

180day U.S. interest rate = 4%

Given this information, is covered interest arbitrage worth­while for Mexican investors who have pesos to invest? Explain your answer. Assume you have 1,000,000 Pesos to invest (MXP).

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Answer 1

Let us assume that the arbitrager has take a loan of 1,000,000 pesos from bank @ 6% for 180 days.

*As nothing is clearly mentioned in the question, we assume rates are for 180 days.

Now, he convert the same into $.

Spot Rate, 1 Mexican Peso = $ 0.100

Therefore, 1,000,000 Mexican Pesos = $ 1,000,000 * 0.1

= $ 100,000

Now the arbitarger invest the same in US market @4% for 180 Days.

After 180 days,

Investment $ 100,000

Add: Interest $ 4,000 (100,000 * 4%)

Total Investment $ 104,000

Let us convert the same into Pesos.

Forward Rate, 1 Mexican Peso = $ 0.099

$ 104,000 = 104,000 / 0.099 Pesos

= 1,050,505.05 Pesos

Now, he needs to repay the bank

Borrowed Amount 1,000,000 Pesos

Add: Interest 60,000 Pesos

Total Amount 1,060,000 Pesos

Gain / Loss in the process = Amount received - Amount Paid

= 1,050,505.05 - 1,060,000 pesos

= - 9,494.95 Mexican Pesos

Therefore, the arbitrager bear a loss of 9,494,95 Mexican Pesos.

So, this interest arbitrage is not worthwhile.