Analytical Application Factors Affecting Exchange Rates Mexi

                                                                                                                   Analytical Application

                                                                                                         Factors Affecting Exchange Rates

Mexico tends to have much higher inflation than the United States, as well as much higher interest rates. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries.

a. Identify the most obvious economic reason for the persistent depreciation of the peso.

b. High interest rates are commonly expected to strengthen a country’s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet the peso’s value has declined against the dollar over most years, even though Mexican interest rates are typically much higher than U.S. interest rates. Thus it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico’s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico?

c. Why do you think the bid/ask spread is higher for pesos than it is for currencies of industrialized countries? How does this affect a U.S. firm that does substantial in Mexico.

Solution

The main reason for the depreciation of peso is the high inflation in Mexico which creates downward pressure on the currency. The currency of Mexico is not strengthened even with the rise in interest rates because of inflationary pressures. The real interest rates in Mexico may be lower than the interest rates prevailing in Mexico. The investors also understand the weak spot of peso. Hence, the US investors do not prefer to invest in Mexican securities. The bid/ask spread is wider for pesos because the banks have more risk dealing with peso as the currency fluctuates with negative movements. The US firm doing business in Mexico will have to bear increased transaction costs when going for conversion of dollars to pesos and vice versa.