Question

Assume that Calumet Co. will receive 10 million pesos in 15 months. It does not have a relationship with a bank at this time, and therefore cannot obtain a forward contract to hedge its receivables at this time. However, in three months, it will be able to obtain a one-year (12-month) forward contract to hedge its receivables. Today the three-month U.S. interest rate is 3% (not annualized), the 12-month U.S. interest rate is 8%, the three-month Mexican peso interest rate is 5% (not annualized), and the 12-month peso interest rate is 20%. Assume that interest rate parity exists. Assume the international Fisher effect exists. Assume that the existing interest rates are expected to remain constant over time. The spot rate of the Mexican peso today is $.10. Based on this information, estimate the amount of dollars that Calumet Co. will receive in 15 months.

Answer 1

Solution:-

The current spot rate of exchange rate is $0.1 per Mexican Peso. Now, the company can get forward contract only after 3 months and the contract will be based on spot rate existing after 3 months. Therefore, we need to calculate the spot rate after 3 months as follows assuming the interest rate parity holds true:

Expected spot rate after 3 months= Current spot rate*(1+ three months US interest rate)/(1+ three months Mexico interest rate) = $0.1*(1+3%)/(1+5%)= $0.0981

Now, based on this spot rate, the forward rate that can be expected for a 12 month forward contract is as follows:

Expected forward rate= $0.0981*(1+ twelve months US interest rate)/(1+ twelve months Mexico interest rate)= $0.0981*(1+8%)/(1+20%)= $0.0883

Thus, the estimated amount of dollars receivable after 15 months are as follows:

Estimate dollars receivables= 10 million pesos*$0.0883= $883,000