Consider the following information: Spot rate (USD/MXP): bid 20.10 ask 20.20; 1 Year forward rate (USD/MXP) bid: 21.50 ask: 21.95. You earn 0.9% on your deposit and borrow at 1% pa in USD. The corresponding rates in Mexico are 5% and 6%.

U.S. 1 Year MM rates: Lending(bid)rate: 0.90% borrowing(ask) rate: 1.00%. Mexico 1 Year MM rates: Lending (Bid) rate 5.0%, Borrowing(ask) rate 6.00%

Suppose you can mobilize USD 10 million or equivalent MXP.

a) is the 1-year forward rate at interest rate parity?

b) Based on what you found in (a), is there an arbitrage opportunity? if yes, show how you can exploit the opportunity. Briefly discuss how arbitrage activity should affect the spot and forward rates.

HINT: use the following formulas to calculate the interest rate parity bid and ask forward rates. Note that the formula given below is for 1 year forward rates; for shorter or longer periods, we need to adjust interest rates accordingly.

F(bid) = S(bid) X (1+ibid)/(1+iask)

F(ask) = S(bid) X (1+iask)/(1+ibid)

Answer rating: 100% (QA)

a To determine if the 1year forward rate is at interest rate parity we can calculate the forward rat... View the full answer