The nominal interest rate is 8 percent in the United States and 8 percent in Spain. The spot rate of the Mexican peso is $.12, while the 1-year forward rate of the euro is $.11. This situation allows for a profitable covered interest arbitrage strategy. Assume that covered interest arbitrage occurs to capitalize on the existing interest rate and exchange rate situation. Assume that the covered interest arbitrage actions will not have any impact on the interest rates, or on the spot rate of the euro. However, the actions of covered interest arbitrage will cause a change in the forward rate of the Mexican peso to the point where interest rate parity will exist.
a. As investors use covered interest arbitrage to make profits, would their arbitrage involve buying or selling euros forward?
b. Would the covered interest arbitrage cause the forward rate of the euro to increase or decrease?
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