Consider the following business that you could easily create: a business that teaches individuals in a non-U.S. country to speak English. While this business is very basic, it still requires the same type of decisions faced by large MNCs. Assume that you initially establish this business in Mexico.
Details of Your Business. You live in the U.S. You invested $60,000 to establish a business of a language school called EI (Escuela de Ingles) in Mexico City, Mexico. You hire local individuals in Mexico who can speak English and train others how to speak English. You have a small subsidiary in Mexico, which has an office and an attached classroom that you lease. Clients can come to your subsidiary for a 1-month structured course in English, taught by your employees. You advertise in the local newspapers to promote the teaching services offered by your business.
You also serve some individuals from Mexico who have taken English classes and want to come to the U.S. for a one-week intense course in which they can improve and practice their English and practice it.
All revenue and expenses associated with your business are denominated in Mexican pesos. Most of the profits from the business in Mexico are sent to you by your subsidiary at the end of each month. While your expenses are somewhat stable, your revenue varies with the number of clients who sign up for the English-speaking courses in Mexico
You only need to know this background so that you can answer the related questions that are asked about your business. Answer each question as if you were serving on the board of your business or as a manager of the business.
Question 1
Mexican interest rates are normally substantially higher than U.S. interest rates.
a. What does this imply about the inflation differential (Mexico inflation minus U.S. inflation), assuming that the peso interest rate is the same in both countries? Does this imply that the Mexican peso will appreciate or depreciate? Explain.
b. It may be argued that the high Mexican interest rate should entice U.S. investors to invest in Mexican money market securities, which could cause the peso to appreciate. Reconcile this theory with your answer (a). If you believe that the high Mexican interest rate does not entice U.S. investors, explain why.
c. Assume that the difference between Mexican and U.S. interest rates is typically attributed to a difference in expected inflation in the two countries. Also assume that purchasing power parity holds. Do you think that your business cash flows would be adversely affected? In reality, purchasing power parity does not hold consistently. Assume that the inflation differential (Mexico inflation minus U.S. inflation) is not fully offset by the exchange rate movement of the peso. Would this benefit or hurt your business? Now assume that the inflation differential is more than offset by the exchange rate movement of the peso. Would this benefit or hurt your business?
Question 2
a. Mexican interest rates are normally substantially higher than U.S. interest rates. What does this imply about the forward rate as a forecast of the future spot rate?
b. Does the forward rate reflect a forecast of appreciation or depreciation of the Mexican peso? Explain how the degree of the expected change implied by the forward rate forecast is tied to the interest rate differential.
c. Do you think that today's forward rate or today's spot rate of the peso would be a better forecast of the future spot rate of the peso.
Question 3
Recall that your Mexican business invoices in Mexican pesos.
a. You are already aware that a decline in the value of the peso could reduce your dollar cash flows. Yet, according to purchasing power parity, a weak peso should only occur in response to a high level of Mexican inflation, and such high inflation should increase your profits. If this theory holds precisely, your cash flows would not really be exposed. Should you be concerned about your exposure, or not? Explain.
b. If you shift your invoicing policy to be only in dollars, how will your transaction exposure be affected?
c. Why might the demand for your business change if you shift your invoice policy? What are the implications for economic exposure?
Question 4
Mexican interest rates are normally substantially higher than U.S. interest rates.
a. Assuming that interest rate parity exists, do you think hedging with a forward rate would be beneficial if the spot rate of the Mexican peso was expected to decline slightly over time?
b. Would hedging with a money market hedge be beneficial if the spot rate of the Mexican peso was expected to decline slightly over time (assume zero transaction costs)? Explain.
c. What are some limitations on using currency futures or options that may make it difficult for you to perfectly hedge against exchange rate risk over the next year or so.