3. You believe that IRP presently exists. The nominal annual interest rate in Me

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 $.105, and a premium of $0.014 per unit.

You will receive 1 million pesos in one year.

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

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

3. 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

Explanation / Answer

Solution:

1. According to IRP, the forward premium on the peso should be

(1.03)/(1.14) – 1 =–.0965 or –9.65%

Thus, the forward rate is:$.10×[1 + (–.0965)] = $.09035.

To hedge 1 million pesos, you would receive $90,350.

2. The expected percentage change in the Mexican peso according to PPP is:

(1 + .05)/(1 + .04) – 1 = 0.96%.

Thus, the peso’s spot rate is expected to be:$.10×(1.0096) = $.10096

You would receive 1,000,000×$.10096 = $100,960

3. Since the expected spot rate is $0.10096 based on PPP, you could receive $0.10096/unit when you receive pesos. This amount is greater than the exercise price, therefore you would sell the pesos at this rate instead of exercising the option. You would have paid a premium of $0.0014/unit, so you would receive $.09956 per unit ($.10096 – $.0014). Your receivables would convert to 1,000,000×$.09956 = $99,560

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