Question

Virginia has been studying financial markets south of the border and she is convinced that government bonds from Mexico, currently offering a 6.8% annual yield (treat this as the interest rate), are worth taking a chance on even though Virginia predicts some modest depreciation in the Mexican peso against the U.S. dollar in the coming year. Assume the current exchange rate in direct terms is 0.04.

If Virginia's financial model anticipates a 2% depreciation in the peso, then how much would 5000 U.S. dollars invested in these Mexican bonds return to Virginia in one year's time?

Express your answer in U.S. dollars.

Answer 1

SOLUTION:

GIVEN INFORMATION:

exchange rate = 0.04

amount invested = $5000

depreciation of peso = 2%

annual returns on mexican bond = 6.8%

step 1; calculation of current exchange rate

given that anticipated depreciation in the exchange rate is 2%

current exchange rate = 0.04 + depreciation i.e 2% = 0.0408

step 2 ; calculation of amount invested in terms of peso.

= Amount invested in terms of $ / 0,0408

= $5000 / 0.0408

= 122549.02 peso

step 3; calculation of annual returns on mexican bonds for given rate of returns.

= 122549.02 * 6.8%

= 8333.33 peso

step 4; convertion of annual returns from peso to U.s. dollar

= 8333.33* 0.0408

= $340