Question

17. During the 1960s and into the 1970s, the Mexican government pegged the value of the Mexican peso to the US dollar at 15 pesos per dollar. Because interest rates in Mexico were higher than those in the US, many investors (including banks) bought bonds in Mexico to earn higher returns than were available in the US. The benefits of the higher interest rates, however, masked the possibility that the peso would be allowed to float and would lose substantial value compared to the dollar. Suppose you an investor and believe that the probability of the exchange rate for the next year remains at 15 pesos per dollar is 0.5, but the rate could soar to 30 per dollar with probability 0.5. (a) Consider two investments: Deposit $1,000 today in a U.S. savings account that pays 10% annual interest, or deposit $1,000 in a Mexican account that pays 18% interest. The latter requires converting the dollars into pesos at the current rate of 15 pesos/dollar, and then after a year converting the pesos back into dollars at whatever rate then applies. Which choice has the higher expected value in one year? (b) Now suppose you are a Mexican with 15,000 pesos to invest. You can convert these pesos to dollars, collect 10% interest, and then convert them back at the end of the year, or you can get 18% from your local Mexican investment. Compare the expected value in pesos of each of these investments. Which looks better?

          17. During the 1960s and into the 1970s, the Mexican government pegged the value of the Mexican peso to the US dollar at 15 pesos per dollar. Because interest rates in Mexico were higher than those in the US, many investors (including banks) bought bonds in Mexico to earn higher returns than were available in the US. The benefits of the higher interest rates, however, masked the possibility that the peso would be allowed to float and would lose substantial value compared to the dollar. Suppose you an investor and believe that the probability of the exchange rate for the next year remains at 15 pesos per dollar is 0.5, but the rate could soar to 30 per dollar with probability 0.5. (a) Consider two investments: Deposit $1,000 today in a U.S. savings account that pays 10% annual interest, or deposit $1,000 in a Mexican account that pays 18% interest. The latter requires converting the dollars into pesos at the current rate of 15 pesos/dollar, and then after a year converting the pesos back into dollars at whatever rate then applies. Which choice has the higher expected value in one year? (b) Now suppose you are a Mexican with 15,000 pesos to invest. You can convert these pesos to dollars, collect 10% interest, and then convert them back at the end of the year, or you can get 18% from your local Mexican investment. Compare the expected value in pesos of each of these investments. Which looks better?

17. During the 1960s and into the 1970s, the Mexican government pegged the value of the Mexican peso to the US dollar at 15 pesos per dollar. Because interest rates in Mexico were higher than those in the US, many investors (including banks) bought bonds in Mexico to earn higher returns than were available in the US. The benefits of the higher interest rates, however, masked the possibility that the peso would be allowed to float and would lose substantial value compared to the dollar. Suppose you an investor and believe that the probability of the exchange rate for the next year remains at 15 pesos per dollar is 0.5, but the rate could soar to 30 per dollar with probability 0.5. (a) Consider two investments: Deposit 1,000 today in a U.S. savings account that pays 10% annual interest, or deposit $1,000 in a Mexican account that pays 18% interest. The latter requires converting the dollars into pesos at the current rate of 15 pesos/dollar, and then after a year converting the pesos back into dollars at whatever rate then applies. Which choice has the higher expected value in one year? (b) Now suppose you are a Mexican with 15,000 pesos to invest. You can convert these pesos to dollars, collect 10% interest, and then convert them back at the end of the year, or you can get 18% from your local Mexican investment. Compare the expected value in pesos of each of these investments. Which looks better?

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