Covered Interest Arbitrage Taking advantage of the “carry trade” Spot rate = 19 pesos/$ One year Forward Rate = 20 pesos/$ You have $1,000,000. Interest Rates: One year Govt debt Mexico 7% USA Rate 1% Can you make money off of this ? What are the effects of covered interest arbitrage? What should the forward rate be to eliminate this arbitrage opportunity? Note: Calculation of % premium or discount. Premium or discount size should be equal to but opposite in sign to interest rate differential. [(Fwd – Spot)/Spot] X 12/n X 100 = % premium or discount Use this formula with direct rates (units of local currency per one unit of foreign) Indirect rates are units of foreign currency per one unit of local currency

Covered Interest Arbitrage Taking advantage of the “carry trade” Spot rate = 19 pesos/$ One year Forward Rate = 20 pesos/$ You have $1,000,000. Interest Rates: One year Govt debt Mexico 7% USA Rate 1% Can you make money off of this ? What are the effects of covered interest arbitrage? What should the forward rate be to eliminate this arbitrage opportunity? Note: Calculation of % premium or discount. Premium or discount size should be equal to but opposite in sign to interest rate differential. [(Fwd – Spot)/Spot] X 12/n X 100 = % premium or discount Use this formula with direct rates (units of local currency per one unit of foreign) Indirect rates are units of foreign currency per one unit of local currency

International Financial Management

14th Edition

ISBN:9780357130698

Author:Madura

Publisher:Madura

Chapter20: Short-term Financing

Section: Chapter Questions

Problem 11QA

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Question

Covered Interest Arbitrage

Taking advantage of the “carry trade”

Spot rate = 19 pesos/$

One year Forward Rate = 20 pesos/$

You have $1,000,000.

Interest Rates: One year Govt debt

Mexico 7%

USA Rate 1%

Can you make money off of this ?

What are the effects of covered interest arbitrage?

What should the forward rate be to eliminate this arbitrage opportunity?

Note: Calculation of % premium or discount. Premium or discount size should be equal to but opposite in sign to interest rate differential. [(Fwd – Spot)/Spot] X 12/n X 100 = % premium or discount Use this formula with direct rates (units of local currency per one unit of foreign) Indirect rates are units of foreign currency per one unit of local currency

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