Question
You are an arbitrageur facing the following spot rate and 1- year forward rate on the US dollar (USD) and the Mexican peso (MXP) bid
You are an arbitrageur facing the following spot rate and 1- year forward rate on the US dollar (USD) and the Mexican peso (MXP)
bid | ask | |
s0(USD/MXP) | USD/MXP 0.04 | USD/MXP 0.06 |
F360(USD/MXP) | USD/MSP 0.07 | USD/MXP 0.09 |
Additionally, you observe the following 1-year interest rates in the US and in Mexico
Borrowing | Lending | |
iUS | 1.20% | 1.10% |
iMex | 5.65% | 5.50% |
a) In order to perform an arbitrage, you borrow in one country and invest in the other (i.e., CIA arbitrage). Borrow in the country that you decide, and invest in the other. Assume to borrow 1 unit of the currency of that country. Describe all the steps of the arbitrage. How much is the arbitrage profit? Provide solution using three decimal points.
b) Suppose that you want to set up a currency carry trade. Assume to use 1,000,000 units of the currency of the country you borrow from to implement the trade. What happens if at maturity (i.e., 1 year) the spot rate, , is USD/MXP 0.05? Would you gain or ( /) you lose money from your trade? Provide solution using four decimal points.
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