Interest Earnings & Losses on Mexican Bonds: Fixed vs. Floating Exchange Rate, Study notes of Economics

Download Interest Earnings & Losses on Mexican Bonds: Fixed vs. Floating Exchange Rate and more Study notes Economics in PDF only on Docsity! Class questions: March 30, 2006 Lecture #17 ECON 3633-900 Reading: Chapter 3 (Melvin) Chapter 2 (Eun and Resnick) 1. Consider a US investor who decides to purchase a 3 month Mexican bond. The bond is a discount bond, selling for a price less than the amount the bond matures at. Suppose the purchase price of the bond is Ps 8,000, but the bond matures at Ps 10,000. Suppose it is September and Mexico employs a fixed exchange rate system (Mexico does not currently employ a fixed exchange rate system. Assume that they do for the question). The exchange rate in September is Ps 3.50. i. How much interest is earned (in dollars) if the fixed exchange rate system is still in place when the bond matures in January, such that the exchange rate remains at Ps 3.50? The bond must be purchased for Ps 8,000. The U.S. investor must therefore exchange dollars for pesos to purchase the bond. To purchase Ps8,000, with the exchange rate of Ps 3.50 we get: Ps 8000/(Ps/$)3.50 = $2,285.71. When the bond matures in January, we receive Ps 10,000. We care about our profit in dollars. Therefore, we exchange the pesos for dollars. We will receive (since the exchange rate has not changed): Ps 10,000/(Ps/$) 3.50 = $2,857.14. So in dollars, we paid $2,285.71 to purchase the bond and receive $2,857.14 when it matures. The total interest earnings: $2,857.14 - $2,285.71 = $571.43. ii. Suppose that the Mexican central bank must devalue the peso in December, and then allows the peso to float. Suppose when the bond matures in January, the peso price of the dollar is Ps 5.20. What are the interest earnings or losses (in dollars) from this investment? The amount we pay for the bond has not changed. We still pay $2,285.71. However, when we exchange pesos for dollars in January, we will do so at a rate that is not advantageous. The amount we receive for Ps 10,000 when the peso price of the $ is Ps 5.20 is: