Question

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 $.108, and a premium of $0.01 per unit.

You will receive 12 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.

Answer 1

Answer :

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

Answer :

Calculation of Forward rate by applying IRP ( Interest rate Parity )

= ( 1 + I_h ) / (1 + I_f) X Spot rate

= ( 1+0.14) / (1+ 0.03) x $ 0.10 = $ 0.1107

Here ,

I_h = Interest in home country

I_f = Interest in foreign country

Amount of dollars receive if use a forward hedge = 12 million peso x $ 0.1107 = $ 1.3284 million

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

By using PPP we will caculate future rate ,

= ( 1 + I_h ) / (1 + I_f) X Spot rate = (1+ 0.04) / (1+ 0.05 ) x $ 0.10 = $ 0.0990

I_h = Inflation Rate in home country

I_f = Inflation Rate in foreign country

Expected amount of dollars will receive you do not hedge and believe in purchasing power parity (PPP) = 12 million pesos x $0.0990 = $ 1.1188 Million

3. Determine the amount of dollars that you will expect to receive if you use a currency put option hedge.  

= (Exeresise price - Premium on Put option - Spot rate) x 12 million pesos = ($0.108 -$ 0.01 - $0.10 ) x 12 million pesos = $ - 0.024 milion = Loss of $ 0.024 million

Account for the premium you would pay on the put option = 0.01 $ x 12 million pesos = 0.12 $ million