Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year forward rate of the peso is $.10. If U.S. firms attempt to use covered interest arbitrage, what forces should occur?

Question

Quizplus · Accepted Answer

Covered interest arbitrage involves borrowing in a currency with a low interest rate, converting the borrowed funds into a foreign currency, investing in a foreign country with a higher interest rate, and then simultaneously selling the foreign currency forward to lock in a future exchange rate. In this scenario, the U.S. firm would borrow at 12%, convert the funds to pesos at the spot rate of $.10, invest in Mexico at 14%, and then sell the pesos forward at the one-year forward rate of $.10. However, the forward rate is equal to the expected future spot rate, so if the forward rate is the same as the spot rate, there are no arbitrage opportunities. Therefore, U.S. firms would not engage in covered interest arbitrage in this scenario, and there would be no impact on the spot or forward rates of the peso.

Assume That a U