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International Finance
Ahmed Mohamed El-Sayed Awed
HOME EXAM-FINAL TAKE
21/11/2020
International Finance (Final Take-Home Exam)
1
Question One: The Mexican Peso Crisis
Read the following case and answer the question that follows.
In a word, the 1994 economic crisis in Mexico – often referred to as the
Mexican peso crisis – can be attributed to overspending. But, as with all crises, there
is far more to it than just living beyond one’s means. This story involves rebellion,
assassination, fratricide, corruption, money laundering, de-regulation, a lot of
investor doubt and a near $50 billion bailout. For the country at least, it has a happy
ending.
Although the Mexican peso crisis had a long lead-in time, it came to a head
rather quickly and was dispatched with equal haste. Following almost a decade of
economic stagnation and hyper-inflation, the Mexican government took its first step
towards the liberalization of trade when it signed up to the General Agreement on
Tariffs and Trade (GATT) in 1986. Deregulation of the capital markets and the
banking system followed. In 1992, the ruling Institutional Revolutionary Party (PRI)
signed up to reduce trade barriers with the US and Canada through the structure
known as the North American Free Trade Area (NAFTA).
By the end of 1993, inflation had dropped to 7.05%, the lowest figure in 22
years, and foreign investment was coming in on the back of low US borrowing rates.
To the casual observer, the future for Mexico looked rosy. But there was a catch. Not
only was growth crawling along at an average of only 2.8% a year, but in the build-up
to his final year of office in 1994, Mexico’s President, Carlos Salinas de Gortari, had
set out on a vote-winning but unsustainable spending spree. Major investment
programs in public health and education were underway which, whilst socially
responsible and largely popular, were very public signs of the country’s profligacy.
With the new banking freedom going largely unchecked, the level and quality of
lending started to create ripples of concern amongst the domestic and international
investor community. This concern was exacerbated by the realization that
government spending had expanded the country’s deficit (it went from $6 billion in
1989 to around $20 billion by 1992 when it signed the NAFTA agreement) and it kept
on growing. All the while, the peso’s strength was constricting exports and pushing
up imports, further widening the gap. It was not long before talk of an overvalued
peso started to circulate, in effect signaling the beginning of the end. Adding to
international investor concern was a widely held (but not necessarily correct) view
that Mexico was undergoing a period of political instability. Chief among the worries
was the January 1994 uprising in the state of Chiapas. The Zapatista Army of National
Liberation (Ejército Zapatista de Liberación Nacional, EZLN), a revolutionary leftist
group, had declared (an apparently largely non-violent) war on the Mexican state.
The Zapatistas saw Salinas and his cronies as being out of touch with the will of the
people and therefore an illegitimate power.
International Finance (Final Take-Home Exam)
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Having failed earlier to secure a popular uprising, EZLN turned its attentions
to what it considered to be the divisive nature of Mexico’s signing of the NAFTA
agreement, which came into effect on 1st January 1994. The agreement resulted in
the removal of Article 27 Section VII of the Mexican Constitution. This had assured
land reparations to Mexico’s indigenous people. The New Year’s Day revolt lasted
just two weeks, but EZLN’s grievances were well-timed to punish the government by
further damaging the country’s risk profile in the eyes of the investment community,
putting a higher premium on Mexican assets.
With a sick budget deficit and a current account deficit (now standing at 7%
of GDP) fueled by excessive consumer spending and what was now clearly an over-
valued peso, Salinas’ government needed to find funding from somewhere. It issued
the tesobono (treasury bill), a debt instrument denominated in peso but indexed to
(and paid out in) US dollars.
And then in March 1994, in the build-up to the election, came the
assassination of Salinas’ intended political successor within PRI, Luis Donaldo Colosio.
PRI had been the dominant force in the country for more than 60 years and it looked
very much like Colosio’s election would be a shoo-in. Salinas’ eventual PRI successor,
Ernesto Zedillo, did win in that August’s election, but just one month later, on
28thSeptember 1994, the party’s Secretary General (and Salinas’ brother-in-law),
José Francisco Ruiz Massieu, was also assassinated.
To all intents and purposes, Mexico looked to be in a state of heightened
political instability and funds started to make a quick exit, further damaging the
economy. Ruiz Massieu’s untimely death (untimely in more ways than one) was later
found to be at the hands of Raúl Salinas, the president’s brother, with Ruiz Massieu’s
own brother, Mario Ruiz Massieu, also implicated. The latter’s name was linked to
bank accounts containing some $17m in what appeared to be an attempt at money
laundering. Mario Ruiz Massieu committed suicide in 1999, his suicide note blaming
Zedillo for both his own death and the assassination of his brother.
With each successive damaging blow, tesobono investors were offloading
them like they were going out of fashion – and they were. Paying out in dollars
further depleted the already low central bank reserves (these hit a reported record
low of $9 billion). In order to maintain the fixed exchange rate (set at 3.3 pesos per
dollar) pushing up interest rates would perhaps have been a prudent move. But it
was election year, and so the central bank, Banco de México, under Salinas’
direction, instead depleted its reserves by getting heavily into Mexican treasury
securities.
With inflation having soared to over 50% as his tenure was coming to an end,
Salinas knew that the game was up. But he was absolutely determined not to
International Finance (Final Take-Home Exam)
3
devalue the peso on his watch. In trying to support the country’s currency, Mexico
deployed yet more of its hard foreign currency holdings, an act which cost it dearly.
Nonetheless, devaluation of the peso was inevitable. When it finally came, on
22nd December 1994, the loss of face fell to Zedillo’s government which had only
assumed power 22 days earlier. Initially, Zedillo had broken an electoral promise and
reversed the Salinas administration’s attempts to keep the fixed rate peso-dollar rate
by allowing an increase of the rate band to 15%. Apart from skating on political thin
ice, economically this was too little, too late. Letting the rate float saw the peso
plummet from 4 pesos per dollar to 7.2 pesos per dollar – within one week.
According to the Institute for International Economics, commenting on the
‘macroeconomic policy mistakes’ that led to Mexico’s crisis, the announcement of
the intended devaluation was unwisely made mid-week, leaving the government
powerless to stop foreign investors abandoning the Mexican market until the
following Monday by which point, of course, the damage had been done. Salinas
later blamed Zedillo for the outcome, citing his successor’s ‘inept’ handling of the
situation, referring to it as ‘el Error de Diciembre’ or ‘the December Mistake’.
Just as EZLN’s uprising was short-lived but damaging, so too was the Mexican
peso crisis. The US, under Bill Clinton’s leadership, stepped into the breach almost
immediately. It started by buying pesos in the open market. It then created a
package via the US treasury’s Exchange Stabilization Fund (as opposed to having the
US central bank intervene directly, Clinton having failed to get his Mexico
Stabilization Act passed by Congress). The deal also involved the Canadian central
bank, the IMF and the Bank for International Settlements, all guaranteeing Mexico’s
loans and reported to be worth in the region of $50 billion.
In less than 18 months, the Mexican economy was on the up. Between 1995
and 2000, the annual rate growth averaged 5.1%, with GDP growth at 5.5% by 2010
(based on figures from national newspaper, El Economista). According to IMF figures,
as of March 2011, foreign reserves were $128.299 billion and nominal GDP in 2012
stands at $1.231 trillion. The World Bank places Mexico as nominally the 13th largest
economy in the world.
Question:
Use the above information to critically analyze the government possible
intervention in the foreign exchange market, highlighting possible rationales of
intervention, different types of interventions, tools of intervention, and most
importantly the potential effect(s) of intervention. Relate your answers to the case
of the Mexican peso crisis as much as you can.
Answer:
There are different types of intervention a government can took place as a
tool to affect foreign exchange market which includes decentralization and
centralization of economy ,globalization ,direct purchase of foreign currency or
International Finance (Final Take-Home Exam)
4
domestic currency from market , issuing bond , increase or decrease public
expenses. There can be direct as well indirect intervention from government side .it
affects not only foreign exchange market as well as economic condition of any
company.
There is possible intervention in foreign exchange market although the
market is governed from itself but time to time government take actions like
devaluation of foreign currency to directly decrease the exchange rate for its own
currency.
The Rationales of interventions are increase or decrease in the
exports/imports, decrease/increase in the value of the currency foreign as well as
domestic, increase/decrease debt of a country, increase/decrease a countries
foreign currency storage, reputation of a country strengthen or week , Investors faith
increase or decrease .
Different type of interventions are direct and indirect and no interventions .I
have already tell about the tools in first paragraph.
Potential effect or rationales are more or same but only difference is that
potential effect is unknown by everyone because the foreign exchange market also
affect by foreign interventions as well as it is auto governed . There may be other
countries who may control your currency.
International Finance (Final Take-Home Exam)
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Question Two: Triangular Arbitrage
As of Sunday, October 27th, 2019, 02:50 pm (GMT) the following quotes
apply.
Currency
Quote
Value of Canadian dollar in U.S. dollars
0.7657
Value of New Zealand dollar in U.S. dollars
0.6349
Value of Canadian dollar in New Zealand dollars
1.2298
Question:
Given the information above, is “triangular arbitrage” possible? Why? Or Why
not? If it is possible, explain the steps that would reflect the “triangular arbitrage”
process and compute the potential profit from this strategy if you had 1,000,000 USD
at your disposal to use for this purpose.
Answer:
Arbitrage means buying in one market and simultaneously setting in another
market to make risk free profit when a mismatch between prices in the two markets
exists.
Generally, two types of arbitrage opportunity exists in the market:
1- Simple arbitrage: when there is a difference in the quotation of exchange
rates in different markets, it is possible when the quote rate in a foreign
market is not exist inverse of the same rate quoted in the home market.
2- Triangular arbitrage: whenever in the arbitrage opportunity, the cross
rate is out of line, triangular arbitrage opportunity exists.
In order to identify arbitrage opportunity; the implicit cross-rate between C$
and NZ$ is calculated as follows:
Cross Rate NZ$/C$:
= Value of Canadian dollar in U.S. dollar / value of New Zealand dollar in U.S.
dollar
= 0.7657 / 0.6349
= NZ$ 1.206 / C$ 1
Thus, the implicit cross rate is NZ$ 1.206 / C$ 1, however, the quoted cross
rate is NZ$ 1.2298 / C$ 1 which is higher than the implicit cross rate. Thus, triangular
arbitrage exists.
International Finance (Final Take-Home Exam)
The following strategy is implemented to earn profit from triangular arbitrage
Description
Calculation
Result
Currency
First step: Available fund is 1,000,000
1,000,000
$
Second step: Buy C$ at exchange rate
of $ 0.7657 / C$ 1
1,000,000 / 0.7657
1,305,994.51
C$
Third step: Buy NZ$ using C$ at
market cross exchange rate of NZ$
1,305,994.51 x 1.2298
1,606,112
NZ$
