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Homework answers / question archive / You believe that IRP presently exists
You believe that IRP presently exists. The nominal annual interest rate in Mexico is 13%. The nominal annual interest rate in the U.S. is 4%. You expect that annual inflation will be about 4% in Mexico and 4.5% 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 $.1008, 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.
a.)
Based on IRP, forward premium on peso = (1 + 4%) / (1 + 13%) - 1
= 0.92035 - 1
= -0.07965 or -7.96%
Forward Rate = $0.10 * [(1+ (-0.07965)]
= $ 0.09204 million
For hedging 1 million pesos, $ 0.09204 million will be received.
b.)
Under PPP, % change in peso = (1 + 4.5%) / (1 + 4%) - 1
= 1.00481 - 1
= 0.004808 or 0.48%
Expected peso's spot rate = $0.10 * (1 + 0.48%)
= $0.10048
Expected amount to be received = $1 million * $ 0.10048
= $ 100480
c. )
Expected spot rate = $0.10048
Expected amount to be received = $0.10048 per unit
Premium paid = $0.014 per unit
Net expected amount to be received = $0.10048- $0.014
= $ 0.08648 per unit
Net expected amount to be received = $1 million * $ 0.08648
= $ 86480
