Question

A Mexican firm will receive $1 million from a U.S. customer in three months. The spot exchange rate is 0.04889 U.S. dollars per Mexican peso, and the three-month forward exchange rate is 0.04842 U.S. dollars per Mexican peso. The firm is considering two strategies to eliminate its foreign exchange exposure.

a. The first strategy is to pledge the $1 million as collateral for a three-month loan from a U.S. bank at 0.52% interest (compounded quarterly). The Mexican firm will then convert the proceeds of the loan to pesos at the spot rate. When the loan is due, the firm will pay the $1 million balance due by handing its U.S. receivable over to the bank. This strategy allows the Mexican firm to “monetize” its receivable immediately. Calculate the present value in pesos if the Mexican firm uses this strategy. [Give your answer to the nearest whole peso.]

b..    The second strategy is to enter a three-month forward contract. This ensures that the Mexican firm will receive 20,652,622.88 pesos in three months. If the firm wanted to monetize this payment immediately, it could take out a three-month loan from a Mexican bank at 5.88% (compounded quarterly), pledging the proceeds of the forward contract as collateral. Calculate the present value in pesos if the Mexican firm uses this strategy. [Give your answer to the nearest whole peso.]

Answer 1

Strategy a.

• Pledge $1 mn receivable in 3 months with US bank at 0.52% interest compounded quarterly

Loan proceeds to the firm = $1 mn cash flow receivable in 3 months discounted at 3 months or 1 period in a 4 period year

i.e. Loan Proceeds = $1mn / (1+0.52%/4)^1               = $1mn / (1+0.0013)        = $1mn/1.00013

                                        = $998,701.69

• Convert the loan proceeds to pesos (Peso) at current spot rate

Spot rate = 0.04889 $/peso

Thus, peso proceeds now from the $loan proceeds                 = $998,701.69 / 0.04889 $/peso

                                                                                                        = Peso 20,427,524.81

• The $1mn proceeds from the US customer in 3 months is then used to settle the US bank loan

Present value of this strategy is 20,427,525 pesos for the Mexican firm

Strategy b.

• Enter into a 3 month forward contract to receive 20,652,622.88 pesos at the forward rate of 0.04842 $/peso
• Pledge the pesos from the forward contract receivable in 3 months with Mexican bank at 5.88% interest compounded quarterly

Loan proceeds to the firm = 20,652,622.88 pesos cash flow receivable in 3 months discounted at 3 months or 1 period in a 4 period year

i.e. Loan Proceeds = 20,652,622.88 pesos / (1+5.88%/4)^1

= 20,652,622.88 pesos / (1+0.0147)          

= 20,652,622.88 pesos /1.0147

= 20,353,427.5 pesos

• The peso cash flows from the forward is then used to settle the Mexican bank loan

Present value of this strategy is 20,353,428 pesos for the Mexican firm

Thus, strategy a is preferable to strategy b.