As a manager at Yucatan Resort, you are considering whether you can increase the holding period return on the companys excess cash holdings (which are held in pesos) by investing those cash holdings in the Mexican bond market. Although you would be investing in a peso-denominated bond, the investment goal is to achieve the highest holding period return, measured in U.S. dollars, on the investment.

The higher yield on the Mexican one-year bond which is assumed to be free of credit risk seems attractive, but you are concerned that depreciation of the peso will reduce the holding period return, measured in U.S. dollars. Economic and financial data for the U.S. and Mexico is given below:

Selected Economic and Financial Data for U.S. and Mexico

Expected U.S. Inflation Rate 2.0% per year Expected Mexican Inflation Rate 6.0% per year U.S. One-year Treasury Bond Yield 2.5%

Mexican One-year Bond Yield 6.5%

Nominal Exchange Rates

Spot 9.5000 Pesos = $ 1.00

One-year Forward 9.8707 Pesos = $ 1.00

a. You are thinking of buying the Mexican one-year bond and hedging the foreign currency exposure using the one-year forward exchange rate. Calculate the U.S. dollar holding period return that would result from that transaction, and compare the result to the holding period return of the U.S. oneyear bond.

After conducting your own analysis of the U.S. and Mexican economies, you expect that both the U.S. inflation rate and the real exchange rate will remain constant over the coming year. Because of favorable political developments in Mexico, however, you expect the Mexican inflation rate (in annual terms) to fall from 6.0% to 3.5% before the end of the year. As a result, you decide to invest Yucatan Resorts cash holdings in the Mexican one-year bond but not to hedge the currency exposure.

b. Calculate the expected exchange rate (pesos per dollar) one year from now, assuming that your expectations about the real exchange rate and the Mexican and U.S. inflation rates are correct.

c. Calculate the expected U.S. dollar holding period return on the Mexican one-year bond, assuming that your expectations about the real exchange rate and the Mexican and U.S. inflation rates are correct.