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Answer: Borrow dollars, convert immediately to pesos and invest in MXN for six months at 7.0%; and enter into (short) futures contract to sell pesos
The Mexican interest rate is much higher than the U.S. rate, so the futures price should reflect that via covered interest parity. Since the quoted futures price is mispriced relative to the spot and interest rate differential, the profitable arbitrage is to: 1. Borrow dollars. 2. Convert the dollars immediately into pesos. 3. Invest the pesos at the higher Mexican interest rate for six months. 4. Enter into a **short futures contract** to sell pesos in six months. This locks in a riskless profit, which the provided solution identifies as USD 113.09. Therefore, the best arbitrage strategy is **C**.
Author: Manit Arora
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718.2. The six-month interest rates in Mexico and the United States are 7.0% and 1.0% per annum, respectively, with continuous compounding. The spot price of the Mexican peso is MXN/USD $0.05650, that is, about 17.70 pesos per one US dollar. If the futures price for a contract deliverable in six months is $0.0610 (i.e., about 16.39 pesos per one US dollar), then which of the following BEST exploits the arbitrage opportunity (this question is inspired by Hull's EOC Problem 5.14)?
A
There is no arbitrage because the futures contract is fairly priced
B
Borrow dollars and invest USD for six months at 1.0%; and enter into (long) futures contract to buy pesos
C
Borrow dollars, convert immediately to pesos and invest in MXN for six months at 7.0%; and enter into (short) futures contract to sell pesos
D
Borrow pesos, convert immediately to dollars and invest in USD for six months at 1.0%; and enter into (long) futures contract to buy pesos
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