1. (hedging) International company (IC), whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties have now increased peso interest rates while dollar interest rates have remained relatively stable. IC must pay interest of 5,000,000 pesos in six months time. The following information is available:

Spot rate: 20.45 USD/MXN

6-month forward rate: 20.90 USD/MXN

Interest rates available for IC are as follows:

Borrow Deposit

Peso interest rates: 100% per year 75% per year

Dollar interest rates: 45% per year 35% per year

Questions:

1. Try to explain what the nature of exchange rate risk here and why IC might consider hedging?

Now assume that there are two possibilities to hedge against exchange rate risk.

1^st Option is based on money market hedge: e.g. the company borrows certain amount of home currency, converts it into pesos and this way hedges against exchange rate risk

2^nd Option is based on forward hedge: e.g. the company buys a forward contract today to hedge against exchange rate risk.

2. Your task is to find, which alternative has cheapest cost in terms of dollars 6-months from now (e.g. when interest payment in pesos is made)