Applying IRP and IFE
Response to the following problem:
Assume that Mexico has a 1-year interest rate that is higher than the U.S. 1-year interest rate. Assume that you believe in the international Fisher effect (IFE) and interest rate parity. Assume zero transaction costs. Ed is based in the United States and attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of 1 year. Ed did not cover his position in the forward market. Maria is based in Mexico and attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars 1 year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of 1 year. Do you think the rate of return on Ed's investment will be higher than, lower than, or the same as the rate of return on Maria's investment? Explain.