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

(a) Does interest arbitrage hold? Is covered interest arbitrage possible? (be brief).

(b) Suppose a typical US investor has $1 million, and a typical Mexican investor has

1 million pesos available for arbitrage transactions. If an arbitrage opportunity is

possible, decide which investor it favors, and the amount of arbitrage profits that

can be gained.