Question

Assume that decide not to implement the marketing campaign that you considered in the previous chapter. 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

Decision between the two alternatives shall be driven by interplay of following factors:

• Spot Exchange rate
• Interest rate on Mexican currency (peso) denominated savings
• Interest rate of dollar denominated savings
• Future exchange rate

Let's say E₀ is the current exchange rate to be interpreted as Peso E₀ required to purchase $ 1. Similarly let E₁ be the exchange rate a year later.

Let interest rate for peso denominated savings to be i_peso and i_$ be the interest rate for dollar denominated savings

Option 1

Let the profit in hands be Peso P

We deposit it in a Mexican bank and earn i_peso. Expected Amount after 1 year = P x (1 + i_peso)

Option 2

Convert Peso P into $ at exchange rate of E₀. Peos P = $ P / E₀

Earn interest i_$ on this. Amount on maturity = $ P / E₀ x (1 + i_$)

Covert this back into Peso at exchange rate E₁ = Peso [P / E₀ x (1 + i_$) x E₁]

Expected amount after 1 year = Peso [P / E₀ x (1 + i_$) x E₁]

Now if expected amount after 1 year in option 1 = P x (1 + i_peso) > expected amount after 1 year in option 2 = [P / E₀ x (1 + i_$) x E₁]

i.e (1 + i_peso) / (1 + i_$) > E₁ / E₀ then choose option 1 otherwise choose option 2

Thus the choice between the two options are governed by interplay of exchange rates and interest rates.