Hedging Decision
Response to the following problem:
You believe that IRP presently exists. The nominal annual interest rate in Mexico is 14 percent. The nominal annual interest rate in the United States is 3 percent. You expect that annual inflation will be about 4 percent in Mexico and 5 percent in the United States. The spot rate of the Mexican peso is $.10. Put options on pesos are available with a 1-year expiration date, an exercise price of $.1008, and a premium of $.014 per unit. You will receive 1 million pesos in 1 year.
a. Determine the expected 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 believe in PPP and use a currency put option hedge. Account for the premium you would pay on the put option.