Assume that a U.S. firm can invest funds for one year in the United States at 12 percent or invest funds in Mexico at 14 percent. 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

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Covered interest arbitrage would involve borrowing in the currency with the lower interest rate (USD in this case) and investing in the currency with the higher interest rate (MXN/Peso). This would increase demand for the peso, causing its spot rate to increase. To hedge against future exchange rate risk, arbitrageurs would sell pesos forward, increasing the supply in the forward market, which would decrease the forward rate of the peso.

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