Redwood Inc. expects that the Mexican peso will depreciate against the dollar fr

Question

Redwood Inc. expects that the Mexican peso will depreciate against the dollar from its spot rate of $0. 053 to $0.050 in 30 days. The company is faced with the following lending and borrowing rates over one year:

Currency

Lending rate

Borrowing rate

U.S. dollar

1.0%

3.3%

Mexican peso

4.5%

8.5%

Assume that the company has a borrowing capability of either $10 million or 70 million pesos. How could Redwood Inc. attempt to capitalize on its expectations? Computed the amount of profit that could realize if the company’s expectation turns out to be accurate.

Currency

Lending rate

Borrowing rate

U.S. dollar

1.0%

3.3%

Mexican peso

4.5%

8.5%

Explanation / Answer

Case 1 : Borrowed $10M

- Borrowed in usa $10M for one month @3.3 %per annum

- Convert into mexican pesos @ spot rate $10M/0.053 = 188Million MXN

- Deposit in mexico 188M MXN for one month @ 4.5% per annum

- Receive MXN 188.705 Million after one month

- convert into $ at depreciated price 188.705*0.050= $9.4 Millions

- pay the loan taken with interest = 10*3.3%12+10M = 10.0275 M

- Loss = 10.0275-9.4 =$ 0.6275M

Case -2 : Borrowed 70m MXN @8.5%

- Borrow mxn 70M

- Convert into $ at spot rate 70M*0.053 =$3.71 M

- deposit in usa @1% per annum for one month

- Recieve amount $3.7131M after one month = 3.71*1%/12+3.71M

- convert into mxn @depreciated rate 3.7131/0.050=74.262 million MXN

- Repay the loan taken after one month with interest 70*8.5%/12+70M = 70.4958Million MXN

- Profit 74.262-70.4958 = 3.7662M MXN

Conclusion :

To Gain the profit from the anticipated depreciation it is better to deposit in usa by borrowing in mexico.

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