Question

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 $.105, and a premium of $0.014 per unit. You will receive 1 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

a. Based on IRP, forward premium on peso = (1 + 3%) / (1 + 14%) - 1

= 0.9035 - 1

= -0.0965 = -9.65%

Forward Rate = $0.10 * [(1+ (-0.0965)]

= $0.09035 million = $90,350

Forhedging 1 million pesos, $90,350 will be received.

b. Under PPP, % change in peso = (1 + 5%) / (1 + 4%) - 1

= 1.0096 - 1

= 0.0096 = 0.96%

Expected peso's spot rate = $0.10 * (1 + 0.96%)

= $0.10096

Expected amount to be received = $1 million * $0.10096

= $100,960

c. Expected spot rate = $0.10096

Expected amount to be received = $0.10096 per unit

Premium paid = $0.0014 per unit

Net expected amount to be received = $0.10096 - $0.0014

= $0.09956 per unit

Net expected amount to be received = $1 million * $0.09956

= $99,560