Assume that a UK firm can invest funds for one year in the UK at 12% or invest funds in Mexico at 14%. The spot rate of the peso is £0.06 while the one-year forward rate of the peso is £0.06. If UK firms attempt to use covered interest arbitrage, what forces should occur?

Question

Quizplus · Accepted Answer

The correct answer is A because covered interest arbitrage will lead to an increase in the spot rate of the peso and a decrease in the forward rate of the peso. This is because UK firms will sell pesos forward to lock in the higher interest rate in Mexico, which will increase the demand for pesos in the spot market and drive up the spot rate. At the same time, the increased supply of pesos in the forward market will drive down the forward rate.

Assume That a UK Firm Can Invest Funds for One