In early December 1994, the Mexican peso was trading at $ 0.30/peso. At the time, the 3‑month peso interest rate was 16% annually in Mexico, 6% annually in the U.S. Since January 1994, when the peso was trading at $ 0.33/peso, inflation had totaled 20% in Mexico, 3% in the U.S.

Three months later, in March 1995, following the peso crisis, the exchange rate was $ 0.20/peso.

Assume that covered interest parity (CIP) held at all times with no transaction costs. (Show your calculations!)

a) What is the 3-month forward rate for peso that is implied by covered interest parity (CIP)? (Hint: Be careful, you are given the annual interest rates)

b)  How many dollars would a speculator have made/lost if she had sold 1 million pesos forward against the dollar in early December 1994?

c)  Compute the real value of the peso between January 94 and December 94 (Hint: set the price level at 100 for both countries as a starting point in January 94). Explain what happened to the real value of the peso- did it appreciate or depreciate? 

d) Now assume that the Relative Purchasing Power Parity (RPPP) holds so that real exchange rates are constant. What nominal exchange rate in early December 1994 would have restored January 1994 level of the real exchange rate for the dollar‑peso?

Answer rating: 100% (QA)

a To calculate the 3month forward rate implied by covered interest parity CIP we need to consider the interest rate differentials between Mexico and t... View the full answer