Blue Demon Bank expects that the Mexican peso will appreciate against the dollar

Question

Blue Demon Bank expects that the Mexican peso will appreciate against the dollar from its spot rate of $.14 to $.15 in 10 days. The following interbank lending and borrowing rates exist:

                                      Lending Rate        Borrowing Rate

      U.S. dollar                     8.0%                       8.3%

      Mexican peso                8.5%                       8.7%

      Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peso in the interbank market, depending on which currency it wants to borrow.

      a.   How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

      b.   Assume all the preceding information with this exception: Blue Demon Bank expects the peso to depreciate from its present spot rate of $.17 to $.15 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

Explanation / Answer

A.

Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows:

1. Borrow $10 million

2. Convert the $10 million to MXP = $10,000,000 / 0.14 = MXP71,428,571

3. Lend the MXP through the interbank market at 8.5% annualized over a 10 day period. The amount accumulated in 10 days is:
MXP71,428,571 × [1 + (8.5% × 10/365)] = MXP71,594,912

4. Repay the dollar loan. The repayment amount on the dollar loan is:
$10,000,000 × [1 + (8.3% × 10/365)] = $10,022,740

5. Convert the MXP to dollars to repay the loan. The amount of dollars to be received in 10 days (based on the expected spot rate of $.15) is: MXP71,594,912 × $.15 = $10,739,237

6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: $10,739,237 - $10,022,740 = $716,497

B.

Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows:

1. Borrow MXP70 million

2. Convert the MXP70 million to dollars: MXP70,000,000 × $.17 = $11,900,000

3. Lend the dollars through the interbank market at 8.0% annualized over a 30 day period. The amount accumulated in 10 days is:
$11,900,000 × [1 + (8% × 10/365)] = $11,978,247

4. Repay the peso loan. The repayment amount on the peso loan is:
MXP70,000,000 × [1 + (8.7% × 30/365)] = MXP70,500,548

5. Based on the expected spot rate of $.15, the amount of dollars needed to repay the peso loan is: MXP70,500,548 * $0.15 = $10,575,082

6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: $11,978,247 - $10,575,082 = $1,403,165

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