International Finance
1
a. Discuss the corporate control of your business. Explain why your business in Mexico is exposed to agency problems.
b. How would you attempt to monitor the ongoing operations of the business?
c. Explain how you might be able to use a compensation plan that limits the potential agency problems?
d. Assume that you have been approached by a competitor in Mexico to engage in a joint venture. The competitor would offer the classroom facilities (so that you would not need to rent classroom facilities), while your employees would provide the teaching. You would split the profits with this business. Discuss how your potential return and your risk would change if you pursue the joint venture.
e. Explain the conditions that would cause your business to be adversely affected by exchange rate movements.
f. Explain how your business could be adversely affected by political risk.
ANSWER:
a. There could be number of reasons that could give rise to the agency problem in Mexico. The main reason for the existence of the agency problem is the employees. These employees might not put their effort fully or do their best to achieve the organizational objectives. They might ignore their responsibility while use the authority to achieve the personal goal before organizational goal. Because the business will be located in Mexico, there might be difficulty in setting up the mechanism to monitor and control the business activity.
b. The most feasible way to monitor the ongoing operations of the business is to set up the daily or weekly or monthly reporting by the employees. The mechanism can be installed whereby the employees are made to report the every business activity like sales, revenue, or other business activities at a certain interval of time regularly through any possible means.
c. One best compensation plan could be the pay per performance. The employees could be paid according to their performance measured in terms of some financial metrics like annual profits. If they are paid according to the total profits or the total sales made, then they will work harder to generate more profits.
d. By the joint venture, the total cost of operation would decrease. However, this will also reduce the potential return because the profit is shared with the partner. This joint venture will also reduce the risk associated with the business because the amount of foreign currency flow will decrease because the profits earned will be divided with the partmer as a result the less amount of foregin currency needs to be converted to dollars.
e. In the case when the peso becomes weaker as compared to the dollar, then the total profits that would be remitted to the United States will decrease. The total profits measured in terms of dollar will be reduced if the dollar becomes stronger.
f. If the existing political stability in Mexico gets disturbed by any factor, then it will affect the business. In addition to this, if the relation between the United States and Mexico gets some friction, then Mexican would reject the services offered by the company, which will ultimately the overall business.
2
ANSWER:
The financial market in Mexico could serve as the source of funds for the business. The business could achieve the short termed business loans to finance the short term business obligations. In addition to this, the business can also get short-term and long-term loans from the financial market to meet the medium and long term financing needs. The bond and stock market could also serve the business as the market to collect more money to be invested in the business.
3
Given the factors that affect the value of a foreign currency, describe the type of economic or other conditions in Mexico that could cause the Mexican peso to weaken, and therefore to adversely affect your business.
ANSWER:
If the business frequently converts the pesos to dollars to remit it to the United States, then the business would be affected if the peso weakens. Several factors might weaken the peso as compared to dollars. Some of them are the very high inflation in Mexico, very low interest rate in Mexico. In addition to this, if the Mexican peso is taken out of the country for speculative purpose, then the peso depreciates.
4
Explain how currency futures could be used to hedge your business in Mexico. Explain how currency options could be used to hedge your business in Mexico.
ANSWER:
Currency futures can be used in two different ways to hedge the business in Mexico.
One could sell the futures of Mexican peso to hedge the expected profits earned from the business in Mexico, which later needs to be converted to dollars. On the other way, one can buy the put option on Mexican peso to hedge the expected profits earned from the business in Mexico, which later needs to be converted to dollars.
5
Mexican interest rates are normally substantially higher than U.S. interest rates.
What does this imply about the forward premium or discount of the Mexican peso?
What does this imply about your business using the forward or futures contracts to hedge your periodic profits in pesos that must be converted into dollars?
Do you think you would frequently hedge your exposure to Mexican pesos? Explain your answer.
ANSWER:
If the Mexican interest rates were higher than the US interest rate, then the forward would be sold at a discount. When the forwards are sold at discount, then such forward or future contract will generate less amount of dollar than the amount of dollars that would be available today i.e. dollar at the spot rate.
In case of hedging at the forward rate, you are selecting an exchange rate which can actually be much below the spot rate of today. Despite the low rate, you would still be interested in hedging due to the expectation towards the future rate. The sport rate in the future period when you try to exchange the peso into dollars can be less than the existing forward rate that you are receiving at present. So, hedging at forward rate despite the low spot rate is also preferable.
In order to decide if you want to hedge frequently, you should be able to understand the tradeoff attached to doing the hedge. There two conditions that need to be accepted i.e. either to consent a large discount while hedging with forward contracts or to survive the given risk with the fluctuation in the exchange rate. However, there is an additional option known as put option which would cost higher than forward contracts to capture the same exchange rate due to the premium price attached to the put option. There also exists a flexible opportunity in put option if you do not exercise the contract and let it expire.
6
Mexican interest rates are normally substantially higher than U.S. interest rates.
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.
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.
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?
Assume that the nominal interest rate in Mexico is presently much higher than the interest rate in the U.S., which is due to a high rate of expected inflation in Mexico. You consider implementing a marketing campaign in which you would hire a local firm to promote your business, but you would have to borrow funds to finance this campaign. A consultant advises you to delay the marketing campaign for a year, so that you can capitalize on the high nominal interest rate in Mexico. He suggests that you retain the profits that you would normally have remitted to the U.S., and deposit them in a Mexican bank. The Mexican peso cash flows that your business deposits will grow at a high rate of interest over the year. Should you follow the advice of the consultant?
ANSWER:
While comparing the inflation differential, the nominal rate of interest being higher suggests the greater level of expected inflation in the economy. Based on the purchasing power parity of Mexican economy, the peso is likely to depreciate.
The difference between Mexican inflation and U.S. inflation must be a positive number suggesting greater inflation in Mexico. According to the purchasing power parity, the high level of inflation in Mexican economy will lead to depreciation of Mexican peso. The cash flow of the business will not be affected in case the purchasing power parity is held constant. So, the revenue as well as the expenses will change by the same amount due to higher inflation, which will also increase the profit margin in peso. The increase in profit is counterbalanced by the decrease in the value of peso.
In case the difference is not being totally equalized, the gain in the cash flow due to inflation will not entirely be balanced by the depreciation of peso. In case of the difference being more than offset, the benefit from the cash flow will be more than fully offset by the depreciation.
The U.S. investors would only take advantage of the high Mexican interest rates if they believe that the returns will be greater than in U.S. after considering the change in exchange rate. In case of the decrease in peso during the investment time, the investment will create low level of return for U.S. investors. If there are chances of high inflation in Mexico, U.S. investors will be worried about the depreciation in the value of peso and will not invest in its securities. Additionally, the greater interest rate will symbolize a weak peso due to the possibility of inflation leading to concerns on investment.
In the given situation, the consultant has not rationally understood about the indication of high interest rate leads to a greater expectation of increase in inflation. As the funds will receive high interest, the price level in the Mexican market will also be rising. So, the price that is allocated for spending in the marketing campaign will be greater than the amount collected from the interest on the funds. Thus, the campaign must not be delayed for the sake of increase in nominal interest rate in Mexico.
