 # Exchange arbitrage

The Mexican direct forward ex rate with the US dollar is higher than that indicated by interewst rate parity. WHich of the folllowing choices would NOT be part of a currency trader’s risk free profit? 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 mexican interest rate

a?

1+Rd < (1+Rf)*Forward/Spot So you want to borrow at domestic rate - Mexican - (it’s cheaper) and lend at the other. Or you want to lend at US (which is foreign in this case) rate. Or you want to sell the Forward. Selling USD at spot would not help you. So A.

Ill go with A as well

A

Ya it is A guys. THx for the explaination

Can u guys explain why you want to lend at US rate, or sell US forward rate? i can’t seem to figure out the relationship

1+Rd < (1+Rf)*Forward/Spot i will give it a try interest rates should be the same if you adjusted them for the currecy impact what the equation above tells you is that interest rate offered in mexic is less than interest adjusted in uS So you can gain from it.How would you do it?try to follow on the equation You would borrow at the lower rate- RD-mexic then you would buy us at the spot rate- that’s why spot rate is in denominator Then you would put that money in the bank at the higher us interest rates. in the mean time you would sell the money you will receive from your deposit at the forward rate locking a profit Makes sense?

If we sell the US forward for which the US exchange rate is low, wont we be at a loss?

CAn someoone ans this question.? thanks

how would you know that the us exhange rate is low for us for forward?

it says that the Mexican direct forward ex rate with the US dollar is higher than that indicated by interewst rate parity. So i assumed it means tht US ex will be lower. Am i missing something here?

if the exchange rate is higher than indicated by the interest rate (dc/fc)forward is higher that means you can buy more dc with one fc that is more mexican currency with one dollar. am i wrong?

Yes you are right in that. But after lending in the US, dont we need to convert back to Pesos to repay what we had borrowed. For that if we sell US forwards today, wont we be at a loss since US ex rate is lower ( since the question says tht Mexican rate is higher?)

Smeet, what you’re saying makes sense somewhat, but we have to look at it from the interest rate parity concept as stated in the question. I’m not an expert, but here is how I looked at it: the peso is cheaper based on interest parity, so we would start out borrowing the peso. The next step is to convert it to US\$. To do this, we buy the at the spot rate. Right there, that eliminates choice A. From there we lend the money at the higher US rate and sell the forward to make sure we have our domestic currency back in the end. Hope that helps a little.