Question

Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest funds in Brazil at 18%. The spot rate of the Brazilian real is $.1793 While the one-year forward rate of the real is also $.1793. If a U.S. firm uses covered interest arbitrage. which of the following price adjustments should result? Spot rate of real increases, forward rate of real increases. Spotrate of real decteses, forward rate of reai desteases Spot rate of cexid decresses, fomaid rate of real hcreasel Spot nate of real incressec, foward ate of real decteases. Spot rate of real increavex tonword hase of real remins constant

Answer 1

Covered interest arbitrage with equal interest rates and exchange rates would lead to an increase in both the spot and forward rates of the Brazilian real, as investors seek to capitalize on higher interest rates in Brazil.

Step-by-step explanation:

When analyzing the option of covered interest arbitrage between investments in the U.S. at a 12% interest rate and Brazil at an 18% interest rate, the corresponding exchange rates become critical. If the spot rate and one-year forward rate of the Brazilian real are the same at $0.1793, covered interest arbitrage will drive market adjustments. In theory, if many investors pursue this arbitrage opportunity, the demand for the Brazilian real will increase due to the higher Brazilian interest rate, which should lead to an appreciation of the real in the spot market. Conversely, the forward rate would likely increase if investors lock in the future exchange rate now to ensure their higher returns. Assuming perfect capital mobility and no transaction costs, this would lead to an increase in the spot rate of the real, while the forward rate should also theoretically increase to prevent arbitrage opportunities.