The Case of the Drifting Exchange Rate: TEACHING NOTES

Case Description
A recent expatriate now living in Mexico finds himself treasurer of a foreign
homeowners
association (HOA). The budget of the HOA, for which the treasurer has some
oversight
responsibility, details anticipated expenditures of approximately 5,250,000
pesos. Since most
homeowners are also expatriates the peso denominated budget is converted
to U.S. dollars and
homeowners are billed accordingly. By implication the treasurer must
consider the impact of
fluctuating exchange rates on owners and management. Strategies for
mitigating possible
implications of exchange rate fluctuations are weighed as well.
Intended Audience
This case can be used in personal finance, principles of finance, or
undergraduate international
finance courses. Other course usage is possible depending on the coverage
of topics found
therein.
Purpose
The purpose of this case is to provide students an opportunity to consider
exchange rate
fluctuations and their impact on different stakeholders. Additionally students
have reason to
devise estimation procedures for future exchange rates and reflect on how
they affect business
entities. The case also provides a vehicle for considering currency hedging
techniques in a
unique and interesting setting.
Learning Objectives
This case should allow students to thoughtfully consider how changing
foreign currency
exchange rates affect disparate parties involved in a set of financial
transactions. Users are
required to seek out quoted exchange rate futures as well as formulating
projected rates.
Students must also contemplate other approaches to minimize or eliminate
the complexities
caused by exchange rate fluctuations.
Teaching Strategies
Prior to assigning this case students should be familiar with foreign currency
exchange rates,
currency futures and forward contracts, and formulation approaches for
estimating future

exchange rates.
Suggested Questions:
Note these questions can be provided with the case if more structure is
desired for the students.
Also the professor may use the information provided in Appendix A at the
end of the case or
instruct the students to locate current information on the web to determine
an appropriate answer.
1. Assuming Mr. Bozarth would prefer to use external sources for an
exchange rate, how would
you suggest a rate for converting next years budget from pesos to U.S.
dollars be determined?
2. What alternate methods might Mr. Bozarth propose to the Board for
dealing with foreign
currency fluctuations?
3. How might Mr. Bozarth go about formulating an estimate of the exchange
rate for the
upcoming year rather than relying on external quotes?
4. What are the implications for the owners and the HOA manager of using
the actual foreign
exchange rate as compared to the 10.5 pesos per U.S. dollar rate used in
prior years budgeting
process? How might this influence the owners and managers preferences
regarding the choice
of exchange rate for next years budget?
Suggested solutions:
1. Assuming Mr. Bozarth would prefer to use external sources for an
exchange rate, how
would you suggest a rate for converting next years budget from
pesos to U.S. dollars be
determined?
Randy could utilize one of several websites that provide futures prices for
foreign currencies.
One such website that shows futures prices for 15 months out is:
http://futures.tradingcharts.com/marketquotes/MQ.html
The futures prices provided could be used as an estimate for converting the
pesos denominated
budget into U.S. dollars to derive the quarterly HOA fees.
2. What alternate methods might Mr. Bozarth propose to the Board
for dealing with
foreign currency fluctuations?
Randy could propose denominating the HOA fees in pesos rather than in U.S.
dollars. Since
owners are not all from the U.S. some owners are required to convert from
Canadian dollars or

Euros to U.S. dollars to pay their fees anyway. Denominating in pesos would
simply require all
owners to go through a currency exchange process each quarter. This
approach would eliminate
the variation in the number of pesos available to the management of the
HOA.
Perhaps a more attractive approach (at least for U.S. owners) would be for
the HOA to utilize
forward contracts scheduled for Jan. 1, April 1, July 1, and October 1. In this
way an exact
number of pesos would be provided to management eliminating exchange
rate risk for both
owners and management.
3. How might Mr. Bozarth go about formulating an estimate of the
exchange rate for the
upcoming year rather than relying on external quotes?
Randy could utilize the following formula to set the price for a futures
contract for a given
currency pair:
F = S {(1 + (RQ x T)) (1 + (RB x T))}
Where:
F = the price for the currency futures contract
S = the spot rate for the currency pair
RQ = the interest rate of the quote currency (decimal)
RB = the interest rate of the base currency (decimal)
T = the tenor or time to maturity (in days)
Note: The best way to handle the T is just divide the annual
interest rates by
the fraction of the year you need to estimate. So if you are
estimating 6
months out then take the annual rates and divide by 2. See the
example
below.
(From http://www.fxpedia.com/Currency_Futures Similar formulations can be
found in any
number of finance text books.)
A projection of the money market rate (risk free) in Mexico was found to be
4.50% for the year
20X1. This could be determined using online research. One site that provides
the desired
information is:
http://www.ustreas.gov/offices/domestic-finance/debt-management/interestrate/yield.shtml
The money market rate in the US for the year 20X1 is estimated at about
0.25%. Again there are
various web sites that can be used the estimate this. One such site is:

http://www.money-rates.com/mmarket.htm
The current exchange rate was found to be 13.0302 pesos/US$ on the
following web site:
http://moneycentral.msn.com/investor/market/exchangerates.aspx
So to estimate todays future exchange rate (say six months out, 180 days)
use the formula from
above. The 180 days are the same for each rate. A six month rate is needed.
Therefore the
annual rates given will be cut in half:
US rate = .0025/2 = .00125 The Mexican rate = .045/2 = .0225.
F180 = 13.03 {(1+.0225)/(1+.00125)} = 13.03(1.0212) = 13.306
pesos/US$.
This makes sense because as the exchange rate gets larger it takes more
pesos in the future to buy
a dollar. One way to think of this is by looking at the interest rates. A higher
interest rate (i.e. the
peso vs. the US$) implies a higher expected inflation in Mexico. (Recall that
interest rates are
made up of a real rate plus expected inflation.) This will cause the peso to
lose value faster than
the US$. If that occurs, then it will take more pesos to buy a dollar in the
future, as the answer
above indicates.
How close does this come to the current futures prices? If one looks at the
chart given at the web
site under (1) above and in Appendix 1 they will see that the futures price for
March 20X1 (about
6 months out) is given as 0.075125. This rate is given in terms of US$/peso.
Prices are quoted
this way by convention. Invert the rate to get the peso/US$ future price
which is 13.311
peso/US$. This is essentially the same as the 13.306 calculated above. Other
factors in addition
to the interest rates may enter into the futures price which is ultimately set
by traders in the forex
market. Also one can argue about the interest rate projections for each
country. Nevertheless,
the price of 13.31 Peso/US$ would provide a reasonable estimate of the
exchange rate in six
months. This rate will probably be off somewhat but will likely be decidedly
better than using
prior periods exchange rate of 10.5.
One possible way to proceed is to collect the money in advance based upon
the futures price.
Then when the money is actually spent the condo owners could be debited
or credited by

whatever amount is actually needed to convert dollars to pesos. If the

futures price turns out to
be exactly correct (which it seldom will) then no debiting or crediting will be
needed. Or one
could bill the owners based upon the futures price without subsequent
adjustment. Sometimes
they will win sometimes they will lose but usually by a relatively small
amount. The futures
price is thought to be an unbiased estimator of future spot prices. If this is
true, the amount they
win and lose should even out over time.
4. What are the implications for the owners and the HOA manager of
using the actual
foreign exchange rate as compared to the 10.5 pesos per U.S. dollar
rate used in prior
years budgeting process? How might this influence the owners and
managers
preferences regarding the choice of exchange rate for next years
budget?
The homeowners would likely expect that the recent favorable movement in
exchange rates
would either reduce their cost in terms of dollars or provide a significant
reserve for future
periods. However, this is not the case since the rate used in the
determination of HOA fees is
based on a pre-determined rate rather than the actual exchange rate. And,
since the budget is
denominated in U.S. dollars there is little incentive for management to retain
those funds as a
reserve.
Given the movement in exchange rates, by using the 10.5 rate management
now has considerably
more pesos available than anticipated in the original budget. This makes
managements job
somewhat easier in that they have more funds available to meet their
obligations. The cushion
created by a more favorable exchange rate (i.e. the 10.5 vs. the 13.31) is
probably what
management does not want to give up. Undoubtedly this is a significant
factor relating to their
arguments to keep the 10.5 rate used last year.
Owners would likely prefer utilization of a more recent rate such as the spot
rate of 13.03 pesos
to the U.S. dollar. This of course reduces fees for U.S. owners at least in their
base currency.

One must remember when establishing a policy that the exchange rate can
move in either
direction. If the peso becomes more valuable in comparison to the U.S. dollar
the number of
dollars required to fulfill the budgetary requirements will be greater.
Whatever policy is agreed
upon it needs to be fair and easy to administer. The parties involved
(management and owners)
should avoid creating a policy that will financially cripple the organization or
the homeowners if
there are significant swings in exchange rates.
Epilogue
After much discussion and political wrangling the following compromise
solution was agreed
upon.
The budget was denominated in pesos since this is the functional currency
(the currency in which
virtually all transactions are denominated). Each quarter management
determines the appropriate
billing amount for homeowners in pesos for HOA fees, utilities, and other
services received. The
treasurer, Randy Bozarth, provides to the HOA manager an average
exchange rate for the
previous quarter which is used to convert the peso billing into U.S. dollars. A
statement is then
sent to homeowners which details all of their charges for the quarter
denominated in both pesos
and U.S. dollars. Homeowners can select the currency to use in paying their
HOA fees. If they
are Mexican nationals or are in Mexico and want to pay in pesos they may.
However, many are
not in Mexico and pay in U.S. dollars.
Unfortunately the homeowners ability to select either currency for paying
their fees gives them
the opportunity to game the system by choosing the currency that benefits
them based current
exchange rates. However that does not appear to be a significant issue as
yet.
This is not a perfect solution since HOA fees are billed in advance using last
quarters exchange
rate and gaming is possible. However, utilities and other services are being
billed based on the
average rate actually encountered for the services received. In spite of the
shortcomings the
approach adopted is far superior to using the arbitrary 10.5 rate.