If you decide to implement a m
If you decide to implement a major marketing campaign in Mexico, you will incur high expenses in Mexican pesos. You would need tofinance the cost of your marketing. You could either borrow dollarsat a low interest rate and convert them to Mexican pesos to coverthe cost, or borrow Mexican pesos to cover the cost. You wouldexpect to pay off the loan on a monthly basis over the next yearwith the use of a portion of the revenue you generate from yourbusiness in Mexico.
a. Would your business be more exposed toexchange rate risk if you borrow dollars or Mexican pesos?b. Explain how you would make the decision toborrow dollars versus Mexican pesos. What is the key factor (otherthan the interest rate of each currency) that will determinewhether you should borrow dollars or Mexican pesos.
c. Assume that decide not to implement the marketing campaignexplaine before. You may pursue it next year instead and willattempt to invest some of your profits this year in money marketinvestments, and then use this money to cover the campaign nextyear. You can retain your profits earned this year by investingthem in a Mexican bank where interest rates are high.Alternatively, you could invest the profits in a dollar-denominatedbank account. That is, you could convert your Mexican peso profitsto dollars periodically and accumulate the dollars over the year.At the end of the year, you could convert the dollars back toMexican pesos, so that you can pay for the marketing campaign.Explain how you could decide between these two alternatives.
Answer:
a) Business will be more exposed to exchange rate risk ifborrowed in Dollars. This is because the interest payments will bein Pesos and for every payment, Pesos need to be bought byexchanging dollars. Hence for every installment, we are beingexposed to exchange rate risk. This makes cash flow veryuncertain.
b) If we decide to borrow in Dollars, the exchange rate risk canbe hedged by entering into a swap contract. So the decision has tobe made by considering the potential payoff and loss associatedwith the relevant swap.
c) Firstly, market volatility has to be compared. Whichevermarket is less volatile than the other will be a safer and moreeconomical bet since this is going to be a saving – it cannot betoo risky even considering risk-returns theory. Secondly exchangerate risk is a big factor. We lose in 2 legs – conversion of Pesoprofits to Dollars and again converting back. It has to becalculate if this 2-leg loss makes up for the gain in otherways.
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