Question

3. You believe that IRP presently exists. The nominal annual interest rate in Mexico is 14%. The nominal annual interest rate in the U.S. is 3%. You expect that annual inflation will be about 4% in Mexico and 5% in the U.S. The spot rate of the Mexican peso is $.10. Put options on pesos are available with a one-year expiration date, an exercise price of $.108, and a premium of $0.01 per unit. You will receive 12 million pesos in one year.

a). Determine the amount of dollars that you will receive if you use a forward hedge.

b). Determine the expected amount of dollars that you will receive if you do not hedge and believe in purchasing power parity (PPP).

c). Determine the amount of dollars that you will expect to receive if you use a currency put option hedge. Account for the premium you would pay on the put option.

Answer 1

Solution:

a) By Interest rate parity equation:

F= forward rate for 1year

S= spot rate

F/S = interest rate factor of $ / interest rate factor of Mexican peso

F/ 0.1 = 1.03/1.14

F= 0.103 / 1.14

F= $ 0.090

So by forward hedge we will receive

= 12mn Mexican peso * 0.090

= $ 1.08mn

b) By purchase rate parity equation

Es / S = Inflation factor rate in US / Inflation rate factor in mexico

Es / 0.1 = 1.05 / 1.04

​​Es ​= 0.10*1.05 / 1.04

Es = 0.10

so expected spot rate after 1 year is $ 0.10

so we will receive

= 12mn Mexican peso * 0.10

= $ 1.2mn

c) By using currency put i.e we will buy right to sell 12mn Mexican peso after 1 year @ E= $ 0.108 by paying premium @ $ 0.01 per unit

so premium = 12mn * 0.01/unit

= $ 0.12mn &

inflow from selling 12mn @ E= 0.108

= 12mn * 0.108

= $ 1.296mn

so Net inflow of $ by currency put hedge

= 1.296 - 0.12

= $ 1.176