The relationship between the MXN/USD FX spot and forward price depends on the risk-free interest rate differential between the Mexican peso
and the US dollar (rf
– rd > 0, since 3.75% = 4.0% – 0.25%). Since the Mexican peso rate is 3.75% above the US dollar rate, we would expect that borrowing at a higher Mexican peso rate and lending at a lower US dollar rate
would result in a no-arbitrage forward price at which more Mexican pesos
are required to purchase USD1 in the future, so the Mexican peso is said to
trade at a discount in the forward market versus the US dollar (F0,MXN/USD(T) > S0,MXN/USD).
Can anyone tell me why we borrow at a peso higher rate to lend at low usd? Is this just a mechanism to find no arbitrage setting ?
If the actual rate was different we can make risk free profits
Actual forward rate = 115 too high. USD can buy more JPY than expect.
Buy JPY in forward so sell JPY in spot
Borrow 100 JPY at 20% and have to replay 120 JPY
Covert to 1 USD and deposit at 10% = $1.10
Covert $1,10 at 115 = 126.5 JPY
Pay off loan and gave 6.5 JPY gain
Or only convert enough to pay off loan 120/1.15 = $1.0434
Gain = $0.0566
(Note the amount you want to covert in the ofreard has to be agreed in advance).
If the rate was too low, i.r 105, we can construct a gain where we borrow USD and investing in JPY.
The availability of risk free gains is what forces the forward rate to the arb free level.
Carry trade
Many investors/speculators participate in the carry trade where they borrow in the cheap currency, USD, and invest in the high interest currency, ie JPY.
BUt this trade has currency risk as they don’t hedge their exposure.