Question

Question 1 Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $0.15 to $0.14 in 10 days. The following interbank lending and borrowing rates exist: Lending Rate Borrowing Rate U.S. dollar 8.0% 8.3% Mexican peso 8.5% 8.7% Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits/losses that could be generated from this strategy. (10 Marks) b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $0.15 to $0.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. (10 Marks)

Answer 1

a) The following strategy may be used

i)Today , Borrow 70 million pesos at 8.7% for 10 days

ii) Convert them to US Dollars at $0.15/Peso to get $10.5 million

iii) Deposit/Lend this dollar amount for 10 days at 8%

iv) After 10 days get $10.5 million*(1+10/365*8%) =$10,523,013.70

v) Convert to Peso at $0.14 to get 10523013.70/0.14 = 75,164,383.56 Pesos

vi) Payoff the loan amount = 70 million *(1+0.087*10/365) = 70166849.32 Pesos

and make an arbitrage profit of 4997534.25 Pesos

b) If the mexican Peso is expected to appreciate, the strategy is as follows

i) Today. Borrow $10 million at 8.3% for 30 days

ii) Convert this amount to Mexican Peso at $0.15 to get 10 million/0.15 = 66,666,666.67 Pesos

iii) Deposit/Lend the Peso amount at 8.5% for 30 days

iv) After 30 days, get Peso amount = 66,666,666.67*(1+0.085*30/365) = 67,132,420.09 Pesos

v) Convert the Peso amount to Dollars at $0.17 to get 67132420.09*0.17 = $11412511.42

vi) Payoff the loan amount = 10 million *(1+0.083*30/365) = $10068219.18

and make an arbitrage profit of $1,344,292.24