Question

Answer the following questions regarding speculating with currency futures. Assume that a March futures contract on the Mexican peso was available in January for $0.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $0.092 per peso. a. How could speculators capitalize on this situation, assuming zero transaction costs? (10 points) b. How would such speculative activity affect the difference between the forward contract price and the futures price?

Answer 1

a)	As the futures price for the Peso is less than the forward
	price for Peso, it would be profitable to buy Peso futures
	and sell those Pesos forward.
	The profit would then be $0.002 per Peso that is so traded.
b)	As more and more arbitrageurs would adopt the strategy
	there would be increase in demand for Peso in futures market
	and increase in supply of Peso in the forward market. This will
	lead to the increase in the price of Peso in the future market
	and decrease in its price in the forward market. As such
	transactions increase, the gap between the prices keeps on
	narrowing till it becomes 0. At this stage there would be no
	further arbitrage possibility.