Question

spot rate of mexican peso: 0.1

180 day mexican interest rate: 6%

180 day US interest rate: 5%

180 day forward rate of mexican peso: $0.098

a. US investor has $50,000 to invest. find the return from covered interest arbitage for the US investor

b. Mexican investor 500,000 Mexican pesos to invest. find the return from covered interest arbitage for the Mexican investor

c. realignment of covered interest arbitrage from the presceptive of the mexican investor:

Answer 1

Solution a)

The US investor has the US $ 50,000 to invest.

If he invests the money in Mexico @ 6% he first has to convert the US $ to Mexican peso at the spot rate as

= US $ 50000 / 0.10

= Mexican Peso 500,000

Now, invest these Mexican Peso 500,000 @6% for 180 days

Amount of proceeds generated from the above investment after 180 days:

= Mexican Peso 500,000 * (1+6%)

= Mexican Peso 530,000

Convert the above proceeds using the 180 days forward rate of 0.098 in US $

= Mexican Peso 530,000 * 0.098

= US $ 51940

Now, instead of investing the US $ 50000 in Mexican deposit @ 6% if the US Investor has invested it in the US market @ 5%, for 180 days, the opportunity cost of that investment would have be:

= US $ 50,000 * (1+5%)

= US $ 52,500

Hence, Net loss to the US Investor will be:

= US $ 51940 - US $ 52,500

= - US $ 560

Solution B)

The Mexican investor has the Mexican Peso 500,000 to invest.

If he invests the money in US $ @ 5%, The investor first has to convert the Mexican peso to the US $ at the spot rate as

= Mexican Peso 500,000 * 0.10

= US $ 50,000

Now invest these US $ 50,000 @5% for 180 days

The amount of proceeds generated from the above investment after 180 days will be:

= US $ 50,000 * (1+5%)

= US $ 52,500

Convert the above proceeds using the 180 days forward rate of 0.098 in the Mexican peso

= US $ 52,500 / 0.098

= Mexican Peso 535714.30

Now, the opportunity cost of investing Mexican Peso 500,000 in Mexico @ 6% would have been:

= Mexican Peso 500,000 * (1+6%)

= Mexican Peso 530,000

Hence, Net gain to the Mexican Investor from covered interest Arbitrage will be:

= Mexican Peso 535714.30 - Mexican Peso 530,000

= Mexican Peso 5714.30