A Detailed Analysis of the Mexican Peso Crisis: Financial Implications

This report provides a comprehensive analysis of the Mexican Peso Crisis of 1994-1995. It begins by examining the economic indicators leading up to the crisis, including exchange rate fluctuations, declining foreign reserves, and increasing balance of payments deficits. The report delves into the factors contributing to the crisis, such as the fixing of the Mexican Peso to the US dollar, high inflation, and unsustainable monetary and fiscal policies. It then explores the policy mistakes made by the Mexican government, including ineffective fiscal and monetary policies, allowing significant foreign capital inflows, and maintaining a fixed currency peg. The report concludes by offering lessons for other developing countries, emphasizing the importance of flexible exchange rates, attracting long-term foreign investments, encouraging exports, and maintaining a focus on long-term economic growth and controlled inflation. The report also includes an analysis of a company's foreign exchange risk exposure and hedging strategies related to a sale invoiced in Euros.

Running head: QUESTION
Question
Name of the Student:
Name of the University:
Author Note:

1QUESTION
Table of Contents
Answer to Question 1:................................................................................................................2
Part a:.....................................................................................................................................2
Part b:.....................................................................................................................................2
Part c:.....................................................................................................................................4
Part d:.....................................................................................................................................5
Answer to Question 2:................................................................................................................6
Part a:.....................................................................................................................................6
Part b:.....................................................................................................................................7
Part c:.....................................................................................................................................8
References:...............................................................................................................................10

2QUESTION
Answer to Question 1:
Part a:
The economic indicators during the Mexican crisis showed a series of trend which is
highlighted in the following points,
 The exchange rate of the country was first fixed to the USD to improve credibility and
investor confidence. This was helpful however it led to the significant uncontrolled
appreciation of the currency. This was later pegged to reduce the overvaluation of the
currency which seemed to be a failure which was followed by making the currency
free float leading to the crisis. The currency was significantly appreciated which
depreciated when the uncertainty in the economy increased leading to the crisis
(Monras 2018).
 The foreign reserves declined significantly for the country as the capital inflows of the
country reduced. To maintain the peg on the currency and to check on inflation the
reserves were being used to maintain the trade deficit. The fall in the reserve was
significant as the $33.3 billion reserve fell to $10 billion in a matter of two years. This
was also followed by the further fall in the reserve when the currency was made free
float leading to a fall in reserve by $5 billion (Khan 2018).
 The balance of payments deficit for the country increased significantly as the imports
were increased due to appreciation of the currency. This was also followed by the
reduction in the capital flows to maintain the deficit which led to the deficit to
increase substantially leading to the fall in the foreign currency reserves (Hall 2018).

3QUESTION
Part b:
The country of Mexico was suffering from high level of inflations before the currency
crisis of 1994. The country planned on lowering the inflation in the country by fixing it to the
dollar which was followed by pegging of the currency. Thus, ultimately making the currency
free float led to the start of the crisis (Wilken 2017).
However, various factors were affecting the country before the currency crisis
affected the country. The fixing of currency to the US dollar led to the appreciation of the
Mexican Peso. Thus it made the export business of the country non-competitive to the global
markets, however the imports for the country became cheap. Thus the change in the currency
pegs led to the reduction of inflation in the country which was also followed by increase in
the imports for the country. Also this led to the increase in the portfolio investment of the
country. This led to further increase in the capital inflows of the country. The USD 3.5 billion
amount in 1989 increased to USD 33.3 billion in just 5 years (Reyes, Castro and Landazábal
2020).
The situation before the currency crisis in the country was that it was having a huge
trade deficit or current account deficit of $48 billion while the inflow of private capital was
$57 billion. The portfolio investment in the country before the fixing of the currency was
theoretically non-existent but became around $28.4 billion in 1993. The reason for the
balance of payment difficulties for the country can be summarized in the following points,
 The fixing of the Mexican Peso with the US Dollar earned significant credibility in
the international markets.
 This led to the appreciation of the currency making imports cheaper while exports
became relatively uncompetitive. The imports increased significantly leading to the
deficit of trade being created for the country.

4QUESTION
 This was also accompanied by the increase in the portfolio investment for the country,
primarily in debt instruments. This also leading to the creation of higher level of
current account deficit leading to balance of payment difficulties.
Part c:
The crisis in the country was started in the country due to the implementation of the
ineffective fiscal and monetary policy. The 1st mistake which was done by the policy makers
was to fix the peso with the dollar to curb inflation. This was an effective strategy which was
used by the policy makers but it was suitable only in the short term, as it did reduce the
inflation and led to the rise in the foreign capital reserve of the country (German-Soto and
Brock 2020).
However, this led to the appreciation of the currency to subsequent higher levels
which affected to international trade of the country. The export trade became uncompetitive
in the international markets, however it became a market place for many countries leading to
the rise in imports. The policy maker should had implemented a policy which would had
boosted the export trade for the country. This could had been done by increasing taxes on
imports which would had reduced the imports for the country, while reducing the taxes on
exports. This would had reduced the imports and increased the exports of the country and the
balance of payments deficit would had been reduced significantly by the country.
The 2nd mistake which was made by the country was to allow significant foreign
capital funds to enter the country which led to the appreciation of the currency. The portfolio
which were created by the investors were a flight risk as a slight fear of volatility would make
the investors flee which had happened in the currency crisis. The policy makers should had
made stringent policy of foreign investing which were long term in nature and would bring
economic prosperity in the country. The investments should had been directed towards

5QUESTION
infrastructure, technology and expansion of industries. This would had brought stability to the
economy along with the currency as the investors could not be able to flee with the slightest
hint of volatility. Thus better long term policy of foreign investments would had reduced the
risk of balance of payment crisis for the country and collapse of the currency (Cabello 2020).
The 3rd mistake which had been made by the government is to maintain the fixed peg
of the currency by converting the peso debt to dollar debt to maintain confidence. The risk
which was taken by the investor was transferred to the government for maintaining the
overvaluation of the currency. The government should had made the currency to float rather
than taking the debt, as it would had reduced the burden on the balance of payment of the
country (Sharma 2018).
Part d:
Other developing countries can take a number of useful lessons from the Mexican
crisis and avert a similar crisis in their economy.
 The currency can be made to float freely with conditional pegging, thus the currency
would not become overvalued while the central bank can keep a check on the
appreciation or depreciation of the currency.
 The foreign investments in the country should be attracted for long terms and not for
short terms which would increase the volatility in the exchange rates. The short term
capital flows should be allowed with conditions such that it does not affect the
currency volatility (Hu and Oxley 2017).
 The Exports of the country should also be encouraged for a country along with the
imports so as to keep a check on the balance of payments of the country. The rise in
imports can be reduced by increasing the taxes while exports can be increased by
reducing the taxes.

6QUESTION
 The central bank should focus on the long term objective which is of economic
growth and controlled inflation. If the central bank tries to control the exchange rate it
leads to currency crisis which was witnessed in the Mexican Peso Crisis (Durdu,
Martin, Zer and Frankel 2018).
Answer to Question 2:
Part a:
The company has received an order of GBP 320000, which is to be delivered in 3
months and the amount should be invoiced in Euro. Thus the company has GBP 320000
receivable in 3 months (Du, Wang, Hsu and Lai 2018). The value at the current spot rate as
per USD and EURO is provided below as direct currency conversion is not available, hence
cross currency exchange is being conducted.
Conversion Point 1: GBP to USD conversion at the spot rate.
Step 1: Amount to be converted GBP 320000
Step 2: USD/GBP is 1.8979 and GBP/USD is 0.5269.
Step 3: Thus the value of the goods in USD using the two rates is provided in the table below,
USD/GBP GBP/USD
We would multiply the exchange rate with
the invoice value
We would divide the exchange rate with the
invoice value
= USD (320000*1.8979) = USD (320000/0.5269)
= USD 607328 = USD 607325.9
Conversion Point 2: USD to EURO conversion at the spot rate.

7QUESTION
Step 1: Amount to be converted USD 607328/607325.9
Step 2: EURO/USD is 1.3169 and USD/EURO is 0.7594.
Step 3: Thus the value of the goods in EURO using the two rates is provided in the table
below,
EURO/USD USD/EURO
We would divide the exchange rate with the
USD value of 607328
We would multiply the exchange rate with
the USD value of 607325.9
= EURO (607328/1.3169) = EURO (607325.9*0.7594)
= EURO 461180 = EURO 461203.3
Part b:
The local currency and the functional currency for the company is GBP as it
maintains all of its invoices in GBP. However, since the sale to France requires the invoice to
be made in EURO and the payment would be made after 3 months. The company is now
facing an exchange rate risk since the company would receive its receivable in EURO and
would need to convert in GBP after 3 months. The EURO amount which would be recorded
by the company is EURO 461180 as the amount which is lower due to foreign exchange
volatility. The company would record an accounts receivable of EURO 461180 in its
accounting books (Froot 2019).
This amount would be converted to GBP after 3 months, hence if the spot rate today
is the spot rate after 3 months. The company would incur no foreign currency loss or gain.
However, since the forward rates for the EURO/USD is appreciating and the GBP/USD is
depreciating a volatility is present in the exchange rate. This can lead to a foreign currency

8QUESTION
loss or gain for the company if the today spot rate is not equal to the spot rate after 3 months
(Opie and Riddiough 2019).
The % of foreign currency risk exposure by the company is to the tune of the following
calculations,
Risk Point 1: % Risk in converting from Euro to USD.
% of risk = ((3 month forward rate – Spot Rate)/Spot Rate) * 360/n = (1.3154-1.3181)/1.3181
* 360/90 = 0.-82% appreciating risk
Risk Point 2: % Risk in converting from USD to GBP.
% of risk = (3 month forward rate – Spot Rate)/Spot Rate * 360/n = (1.8990-1.8979)/1.8979 *
360/90 = 0.23% depreciating risk
Thus, by this % the receivable by the company is exposed to the foreign currency risk.
Part c:
Thus the company is exposed to the financial risk and the company should hedge
itself by entering into a series of forward contract. This is done to hedge the receivable which
is in EURO for the company (Chakravorty and Awasthi 2018). Thus, to hedge itself the
company would need to follow the following steps which is provided in the points below,
Step 1: Determine the amount of the receivable.
Thus as the sale has been invoiced by the company and the currency is EURO, the
receivable amount for the company is EURO 461180. Thus this amount would be hedged by
the company.
Step 2: Enter into a forward contract.

9QUESTION
Since the GBP/EURO have no direct currency exchange rate, the company would
need to enter into a forward contract with the USD currency. The company would need to
enter into the 3 month forward contract in to sell the EURO and purchase USD. The company
would be short EURO and Long USD. The exchange rate at which the contract would be
entered is USD/EURO which is 1.3154.
The USD receivable by the company would be after the 3 Month on selling EURO is,
= Exchange rate * EURO receivable = 1.3154 * 461180 = 606636.17 USD.
Step 3: Enter into a forward contract.
The company would enter into another forward contract to exchange the USD which
it has converted from EURO. The amount of the contract which is entered would be USD
606636.17 and would be made at the exchange rate of 1.8990. Thus the GBP which would be
received by the company is,
USD receivable / Exchange Rate = 606636.17/1.8990 = 319450 GBP
Hence the company has hedged its foreign receivable by entering into two different
forward contracts.

10QUESTION
References:
Bush, R. and Woodham, A., 2019. Practical Applications of The New Neutral: The Long-
Term Case for Currency Hedging. Practical Applications, 7(2), pp.1-6.
Cabello, A., 2020. Market efficiency and long run purchasing power parity disequilibria of
the Mexican peso under changing exchange rate regimes. International Journal of Banking
and Finance, 2(1), pp.63-82.
Chakravorty, G. and Awasthi, A., 2018. Dynamic Hedging of Currency Risk in Investment
Strategies. Available at SSRN 3289292.
Clark, E. and Judge, A., 2017. Foreign currency derivatives versus foreign currency debt and
the hedging premium. Evaluating Country Risks for International Investments, pp.381-433.
Du, J., Wang, J.N., Hsu, Y.T. and Lai, K.K., 2018. The importance of hedging currency risk:
Evidence from CNY and CNH. Economic Modelling, 75, pp.81-92.
Durdu, C.B., Martin, A., Zer, I. and Frankel, J., 2018. Comment on “The Role of US
Monetary Policy in Global Banking Crises”.
Froot, K.A., 2019. Currency Hedging Over Long Horizons. Annals of Economics &
Finance, 20(1).
German-Soto, V. and Brock, G., 2020. Are Mexican Manufacturing Workers Underpaid?
Some Quarterly Time Series Evidence. The Journal of Developing Areas, 54(2).
Hall, M.G., 2018. Exchange rate crises in developing countries: the political role of the
banking sector. Routledge.
Hu, Y. and Oxley, L., 2017. Are there bubbles in exchange rates? Some new evidence from
G10 and emerging market economies. Economic Modelling, 64, pp.419-442.

11QUESTION
Khan, S., 2018. Currency Crisis Transmission Through Trade Channel: Asian and Mexican
Crises Revisited. Journal of Economic Integration, 33(4), pp.818-840.
Monras, J., 2018. Immigration and wage dynamics: Evidence from the mexican peso crisis.
Opie, W. and Riddiough, S.J., 2019. Global currency hedging with common risk
factors. Journal of Financial Economics.
Reyes, E.R., Castro, A.M. and Landazábal, N.J.S., 2020. Mexican Stock Exchange
Performance after the Crisis of 2008: Application of Data Mining. Dimensión
Empresarial, 18(1)).
Sharma, S.D., 2018. Beyond the Asian crisis: The evolving international financial
architecture. In The Asian financial crisis. Manchester University Press.
Wilken, G.C., 2017. Bolsa Mexicana de Valores (Mexican Stock Market). Modern
Mexico, 11(1), p.98.