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17 Aug 2018

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.

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Patrina Schowalter
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19 Aug 2018
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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?

The value of each Latin American currency relative to the dollar is dictated by supply and demand conditions between that currency and the dollar. The values of Latin American currencies have generally declined substantially against the dollar over time. Most of these countries have high inflation rates and high interest rates. The data on inflation rates, economic growth, and other economic indicators are subject to error, because limited resources are used to compile the data.

a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of appreciation, depreciation, or no change in any particular Latin American currency? Explain.
b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change in the value of a specific Latin American currency? Explain.
c. Do you think that U.S. firms can accurately forecast the future values of Latin American currencies

Mexico tends to have much higher inflation than the United States, as well as much higher interest rates. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.

a. Identify the most obvious economic reason for the persistent depreciation of the peso.

b. High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet the peso’s value has declined against the dollar over most years, even though Mexican interest rates are typically much higher than U.S. interest rates. Thus it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? c. Why do you think the bid/ask spread is higher for pesos than it is for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico?

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