Question

If you decide to implement a major marketing campaign in Mexico , you will incur high expenses in Mexican pesos. You would need to finance the cost of your marketing. You could either borrow dollars at a low interest rate and convert them to Mexican pesos to cover the cost, or borrow Mexican pesos to cover the cost. You would expect to pay off the loan on a monthly basis over the next year with the use of a portion of the revenue you generate from your business in Mexico.

a.    Would your business be more exposed to exchange rate risk if you borrow dollars or Mexican pesos?
b.    Explain how you would make the decision to borrow dollars versus Mexican pesos. What is the key factor (other than the interest rate of each currency) that will determine whether you should borrow dollars or Mexican pesos.

c. Assume that decide not to implement the marketing campaign explaine before. You may pursue it next year instead and will attempt to invest some of your profits this year in money market investments, and then use this money to cover the campaign next year. You can retain your profits earned this year by investing them in a Mexican bank where interest rates are high. Alternatively, you could invest the profits in a dollar-denominated bank account. That is, you could convert your Mexican peso profits to dollars periodically and accumulate the dollars over the year. At the end of the year, you could convert the dollars back to Mexican pesos, so that you can pay for the marketing campaign. Explain how you could decide between these two alternatives.

Answer 1

a) Business will be more exposed to exchange rate risk if borrowed in Dollars. This is because the interest payments will be in Pesos and for every payment, Pesos need to be bought by exchanging dollars. Hence for every installment, we are being exposed to exchange rate risk. This makes cash flow very uncertain.

b) If we decide to borrow in Dollars, the exchange rate risk can be hedged by entering into a swap contract. So the decision has to be made by considering the potential payoff and loss associated with the relevant swap.

c) Firstly, market volatility has to be compared. Whichever market is less volatile than the other will be a safer and more economical bet since this is going to be a saving - it cannot be too risky even considering risk-returns theory. Secondly exchange rate risk is a big factor. We lose in 2 legs - conversion of Peso profits to Dollars and again converting back. It has to be calculate if this 2-leg loss makes up for the gain in other ways.