The mexican direct forward exchange rate with the U.S. dollar is higher than that indicated by interest rate parity. Which of the following choices would NOT be part of the currency trader’s risk-free profit trading strategy? A) Sell USD at Spot rate (USD/MXP) B) Sell USD Forward C) Lend USD at the U.S. Interest rate D) Borrow the mexican Peso at the Mexican Interest rate The correct answer is A. Arbitrade relationships are very confusing. Is there any easy way to understand whether to sell the spot rate, sell the forward, borrow domestic, borrow foreign etc.?? Any input would be helpful Thanks
buy cheap; sell rich. if the peso forward is rich, the peso spot is cheap. —> buy the peso at spot!!! by doing so you are selling USD then sell the (RICH) forward to complete arb.
if you buy peso at the spot, arent you selling USD to get it? doesnt that contradict answer A?
I think you can think you will always get the cheap currency and give away the expensive currency, but not do the opposite. So in this case now MXP is expensive compared to USD. A) Sell USD at Spot rate (USD/MXP) wrong, getting rid of undervalued currency now. B) Sell USD Forward right, getting rid of undervalued currency now in the future. C) Lend USD at the U.S. Interest rate right, getting rid of undervalued currency now. D) Borrow the mexican Peso at the Mexican Interest rate right, getting overvalued currency now.
I always try to figure out which currency am I going to earn better interest for my money. In this case, MXP fwd is overstated. i.e. Assuming domestic is mexico - 1+Rd < (F/S)*(1+Rf) So, interest rates are higher when holding foreign (US$) So, I will lend US$, and borrow MXP. This would involve me selling MXP at the spot rates, not the US$. Hence, A is the answer.
In equilibrium, returns on currencies will be the same, no profit will be realized, and interest parity exists which can be written 1+ domestic rate = (1+foreign rate)*Forward domestic rate / Spot domestic rate, there is no arbitrage If 1+ domestic rate > (1+foreign rate)*Forward domestic rate / Spot domestic rate, there is arbitrage, borrow foreign If 1+ domestic rate < (1+foreign rate)*Forward domestic rate / Spot domestic rate, there is arbitrage, borrow domestic In this case, the forward being greater than indicated at parity, (1+foreign rate)*Forward domestic rate / Spot domestic rate>(1+foreign rate)*Forward domestic rate AT PARITY / Spot domestic rate So (1+foreign rate)*Forward domestic rate / Spot domestic rate >1+ domestic rate => Borrow domestic, which is Mexico, Mexican pesos (the quotes are direct MXN to $, I am in Mexico…no, I am in Chicago:D
dumb question but if i am selling USD at spot rate, arent i getting Mexican Pesos now, which is what i want? and then i can convert back to USD at the forward rate in the future?
You want to convert USD to MXP in the future. So, USD -> MXP forward, i.e. MXP -> USD spot.
Thanks. I get it now. You guys are awesome.
Thanks everyone!! Good luck!