Money, Banking, and International Finance

Fidelity utilized this financing strategy to earn profits from the large interest rate difference.

 Fidelity borrowed funds from the United States at id = 5% and invested in Mexican funds

and earned the interest rate, if = 12%. Thus, the interest rate differential (iMXN – iUS) is 7%,

while the investment period equals one year.

 Fidelity converted U.S. dollars to Mexican pesos on the spot market at time t to invest in

Mexico and then converted pesos back into U.S. dollars after the investment had matured.

Meanwhile, the U.S. dollar appreciated approximately 5% or e = 5%. Remember, we

defined Mexico as the foreign country while the United States is the domestic country.

We compute Fidelity's expected return from Mexican investment in Equation 23.

   

1 = 67

360 1 0.05

360

1 = 1 +0.12

360 1 +e

T

rd= 1 +if 0. 0

1 1















 











 (23)

Fidelity borrowed funds from a U.S. bank at 5% that we calculated in Equation 24.

= 5

360

360

=0.05

360

T

rd=id 0. 0 (24)^

We calculate the expected profit by subtracting investment earnings from the cost of
borrowing, or 6.7% – 5% = 1.7% per year. Fidelity utilized this strategy during the early 1990s
and earned profits between 1.5% and 11%. Unfortunately, Fidelity lost all its profits in
December 1994 after the Tequila Devaluation. Fidelity used a strategy called an uncovered
position because Fidelity exposed itself to an exchange rate risk because it relied on a future
spot exchange rate. Fidelity should have used a covered position, where it uses derivatives
contracts to protect its future cash flows from a foreign investment.

Interest Rate Parity Theorem

Investors use Interest Rate Parity Theorem to price forward contracts. A forward contract’s
price originates from interest rate difference between countries. Consequently, international
investors move financial capital into countries with higher interest rates. We can examine price
derivatives contracts and predict future exchange rates. We list the mathematical notation below:

 Domestic nominal interest rate in APR equals id while the rate of return is rd.

 Foreign nominal interest rate in APR is if while the foreign rate of return equals rf.

 Currency spot exchange rate at time t is S. We write the exchange rate as a ratio, such as $

per euro.