Question

1. A U.S. firm has a MXN 25,000,000 payable (money they will owe to a supplier, for example) due in 4 months. The current exchange rate is $.082/MXN and the U.S. firm fears the MXN could appreciate substantially over the next 4 months. The interest rate on 4-month MXN money market deposits is 2.50% (a periodic rate, not a yearly rate). How could the U.S. firm execute a money market hedge? (Show everything and include numbers)

Answer 1

So our home currency is Dollar and the MXN is the foreign currency. We need to pay MXN 25,000,000 after 4 months. As the firm is afraid that the MXN currency will appreciate and  want to hedge it by money market, they will convert $ into MXN right now at current exchange rate of $0.82/MXN and deposit it at 2.5% for 4-month.

So today we will convert $X into MXN Y which after keeping at 2.5% after 4 months yield into MXN 25,000,000. As we know that the interest on Y at 2.5% will give 25,000,000, so we will put it in equation.

X(1+0.025) = 25000000

X = 25000000/1.025

X = 24,390,243.9024

So today we will convert X Dollars at $0.082/MXN so that we get 24,390,243.90 MXN

So we will require 0.082 * 24390243.90 = $1,999,999.99

So today we will convert $ 1,999,999.99 (which is equivalent to $ 2 million) into MXN at $0.082/MXN and get MXN 24,390,243.90 which we invest at 2.5% so we get MXN 25,000,000