1. WILLAMETTE UNIVERSITY
Mexico’s Floating Exchange
Rate & Accelerated Capital
Flight
A Microeconomic Investor Behavior Analysis
Marc A Villanueva
4/27/2012
Professor Jerry Gray
ECON 496W Senior Thesis
CLA Economics Department

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Section I. Introduction
During a Federal Law Enforcement investigation, money laundering detective Martin Woods
discovered that from 2004-2007 a massive $378.4 billion dollars had been laundered by Wachovia Bank
from Mexican currency exchange firms known as Casas de Cambios. This discovery prompted additional
investigations to discover the length of time U.S. banks had been laundering dirty money and from what
source the majority of these illicit financial funds were originating from (Smith 2010). Future reports
indicated these massive amounts of illicit financial funds were not only coming from Casas Cambios that
primarily serve Mexican drug cartels but from additional firms in Mexico responsible for transferring
massive amounts of illicit financial funds into U.S. Banks (Smith 2010).
Global Financial Integrity, a not-for-profit research organization that is dedicated to investigating
the sources of illicit financial funds, found that illegal economic activity within Mexico has only been
getting progressively worse (Kar 2012). From 1970-2010, an estimated $872 billion dollars has left
Mexico, and in 1995, these illicit financial flows accounted for an all time high 12.7 percent of Mexico’s
GDP (Kar 2012). Among Mexico’s currency related issues, these increasing outflows of illicit financial
funds are very problematic to maintaining stability of the domestic currency. The outflows have had
detrimental effects on the official exchange rate and currency stabilization measures taken by the
Central Bank of Mexico.
The purpose of this paper is to investigate if Mexico’s transition to a floating exchange rate in
1994 has accelerated illicit financial outflows. Coincidentally, since Mexico’s transition from a fixed to a
floating exchange rate, illicit financial outflows have only increased in relation to a depreciating official
exchange rate. The correlation between these two indicators raises inquiries within both international
and financial economics regarding exchange rate regime and the devaluation risk that holders of
domestic currency may face.

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Illicit financial outflows, otherwise known as capital flight, occur when investors exchange
domestic currency for foreign currency to evade the systematic risk of a potentially volatile domestic
currency. More specifically, this paper will analyze if capital flight increases within a country operating
under a floating exchange rate (National Graduate Institute for Policy Studies 2012). By applying the
Modern Portfolio Theory (MPT) and Krugman Investment Function, this paper will provide the necessary
microeconomic implications that model why investors are led to sending funds abroad.
Applying the microeconomic implications from investor behavior, this paper will then theorize
how capital flight at large has affected domestic Mexican currency operating under a floating exchange
rate. Understanding the effects of capital flight to a floating exchange rate will provide the necessary
evidence indicating whether or not investors are led to increase currency hedging to evade the
systematic risks inherent to the Mexican economy (Flaschel and Semmler 2003).
Section II contains a literature review discussing the progression of the Mexican economy and
an econometric analysis supporting that a floating exchange rate regime increases the incentive for
investors to hedge domestic currency. Section III discusses the models and theories being applied to
analyze how a floating exchange rate has accelerated capital flight within Mexico, and Section IV will be
an empirical analysis incorporating data and models to support that a floating exchange rate regime
increases capital flight. Finally, Section V will be a conclusion summarizing the findings with concluding
solutions, and Section VI will contain data.
Section II. Literature Review
Dev Kar of Global Financial Integrity wrote specifically about the evolution of increasing illicit
financial outflows from Mexico in “Mexico: Illicit Financial Flows, Macroeconomic Imbalances, and the
Underground Economy.” His findings provide an accurate estimate of the cumulative illicit financial
outflows from Mexico to be $872 billion dollars over the period of 1970-2010 (Kar 2012). Each year since

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1970, these illicit financial outflows grew by 10% and accounted for Mexico’s external debt at 15
percent in 1970 to now 28.7 percent in 2010 (Kar 2012). The implications behind both an increasing
external debt and illicit financial outflows suggest that there is an increasing amount of currency
exchanging (hedging) by investors to evade exchange rate risk.
In regards to the progression of Mexico’s macroeconomic state from 1970 to 2010, Kar added
that illicit financial funds being driven out of the country were due to an increasing rate of inflation, an
expanding underground economy and trade openness (Kar 2012). He believes these influential factors
demonstrated how sufficiently large monetary shocks to Mexico’s domestic economy led to a loss in
investor confidence and created a widely anticipated devaluation of the official exchange rate (Kar 2012).
Additionally, Kar added that the underground economy and illicit financial outflows drove each
other through a momentum effect (Kar 2012). The momentum effect is a term used in finance to
describe assets that persistently rise or fall in value over a long period of time (Kar 2012). In Kar’s report,
he recognized this momentum effect since for a long period of time illicit financial outflows have
consistently increased simultaneously with a weakening Mexican exchange rate (Kar 2012).
The method used in this paper to estimate illicit financial outflows was based off the World Bank
Residual Model adjusted for trade mispricing (Kar 2012).Although within a closed economy there are
zero injections and leakages, this model examines an open economy’s gap between source of funds and
use of funds. Source of funds is the composition of net foreign direct investment and inflows of loans
and private equity. Use of funds is the amount of funds used towards financing the current account
deficit and changes in central bank reserves (Kar 2012). If the use of funds exceeds an economy’s source
of funds, it indicates there are leakages within the country’s balance of payments and external account
(Kar 2012). Applying the value indicated as a country’s leakages, Kar recognizes them as gross illicit
outflows (Kar 2012). The outflows are illicit since they are capital (funds) that was illegally obtained and
unrecorded through private capital outflows (Kar 2012). Historically, Mexico’s gross Illicit outflows have

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led to an increasingly large accumulation of foreign assets which have been a large part of the external
debt (Kar 2012).
Different from past studies, this paper’s method for estimating illicit financial outflows accounts
for trade mispricing. Trade mispricing is the process of evading taxes or additional fees when trading
goods. Calculating illicit financial outflows with regard to trade mispricing recognizes the impact of large
scale leakages on a macroeconomic level.
Another significant part of Kar’s financial report is his references to significant economic crises
within Mexico that have led to abrupt capital flight. Most relative is the 1994 Tequila Crises which was
the root cause of Mexico’s transition from a fixed exchange rate to a floating exchange rate (Kar 2012).
One of the main reasons this change to a floating exchange rate occurred was due to high income
Mexicans and foreign investors exchanging (hedging) their domestic Mexican assets for more stable
foreign assets (majority were U.S. assets) (Kar 2012).Since under a fixed exchange rate the government
is responsible for intervening and maintaining (defending) a stable currency, the Mexican government in
the events preceding the 1994 Tequila Crisis was no longer able to maintain a stable currency due to an
uncontrollable current account deficit(Kar 2012).These increasing current account deficits were directly
linked to foreign investors and high income Mexicans hedging domestic assets for foreign assets. As a
result, the Mexican government could no longer supply a sufficient amount of foreign assets to defend a
fixed exchange rate and was forced to devalue the currency by 30%. This devaluation was necessary
since the Mexican government would no longer be required to supply as much foreign assets as before,
but this eventually led to Mexico’s transition to a floating exchange rate to eliminate any further
reliance on the government to maintain the currency’s position (Kar 2012). Since this event, capital
flight has accelerated at an even faster annual rate than ever before. The graph displays this sudden
capital flight acceleration after the change to a floating exchange rate.

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Dev Kar’s macroeconomic report on Mexico’s illicit financial outflows provides updated and
accurately analyzed data indicating the annual amount of capital flight. In addition, the paper recognizes
the methods used by investors to generate illicit financial outflows through trade mispricing.
Kamil Herman’s International Monetary Fund paper “How exchange rate regimes affect firms’
Incentives to Hedge Exchange Rate Risk?” inquires a similar question to the one posed within this paper
except that his is regarding licit financial funds (those that are subject to taxes and other regulations). In
addition, Herman’s methodology for finding a solution is different since it uses a regression analysis
unlike this paper’s application of theoretical models. Regardless of the systematic differences, Herman’s
paper similarly digs deep for a better understanding of how an exchange rate regime affects the
investors’ incentive to hedge exchange rate risk. Applying Herman’s findings will be beneficial since this
paper is attempting to model the behavior of investors in their attempts to evade the systematic risk of
domestic currency.
Herman considers exchange rate regime’s effect on investor’s incentive to hedge currency to be
a widely spoken topic in financial and international economics due to the many global financial crises
(Herman 2008). Historically, fixed or pegged exchange rates have always seemed to be the root cause
0
10
20
30
40
50
60
70
80
90
100
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Billions Mexican Illicit Financial Outflows 1970-2010
Illicit
Financial
Outflow

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behind massive accumulations of unhedged foreign currency, and this has been observed within
currency crises of Asian and Latin American countries (Herman 2008). When firms begin borrowing
foreign currency to take advantage of higher interest rates, this imposes a huge moral hazard on the
government to maintain a stabilized currency that is not prone to potential devaluation (Herman 2008).
Because firms begin borrowing excessive amounts of foreign currency in this manner they do not
anticipate the foreign exchange risks that come with an economic crisis (Herman 2008). Essentially,
pegged exchange rates induce large amounts of currency mismatch vulnerabilities due to the inability of
firms to hedge and offset potential losses (Herman 2008).
The mechanics behind a flexible exchange rate regime is a little different since it reduces the
government’s currency mismatch vulnerabilities under a fixed exchange rate (Herman 2008). Currency
mismatch vulnerability is the inability of firms to pay foreign currency denominated debt due to a falling
value of domestic currency. In this case, the difference between foreign debt and domestic assets
become very unequal. These currency mismatches are more common within a fixed or pegged exchange
rate regime since domestic currency has very limited exchange rate volatility and investors are unaware
of an accumulating foreign currency debt (Herman 2008). On the other hand, when investors take on
either a foreign or domestic currency under a floating exchange rate they are automatically aware of the
value or position of the currency. The mechanics of a floating exchange rate allows the investor to gage
whether or not they should hedge currency to offset a potential loss (Herman 2008). However, Herman
then identifies that a flexible exchange rate may still not reduce currency mismatches since they are in
direct relation to the interest rate risk premium, which is an indicator of exchange rate risk (Herman
2008). The flexibility of the exchange rate will only induce a much higher domestic interest rate since it
leads to a higher incentive to hedge currency and forego low interest rate risk premiums (Herman 2008).
Herman also carried out a regression analysis by taking data from 2,200 firms not within a
financial sector or in seven Latin American countries from 1992 to 2005 (Herman 2008). Different to

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other empirical analyses, Herman used variables that indicate increased exchange rate risk (Herman
2008). Those variables were the share of foreign currency revenues in total sales, the currency
composition of assets and liabilities, and the firms’ access to equity markets and international debt
(Herman 2008). Using these variables, Herman constructed a “Freedom to Float” Index to determine if
there was differing volatility based off exchange rate regime. In his results, higher variance indicated
monetary policies taken by the bank imposed higher volatility as opposed to flexible exchange rate
policies (Herman 2008). The only downside to Herman’s regression analysis is that it only presented a
causal link and did not account for factors that can actually have a detrimental effect on exchange rate
risk (Herman 2008).
The most significant idea Herman’s paper points out is that “the adoption of a floating exchange
rate regime leads to a higher degree of currency matching in firm’s balance sheets, relative to pegged
regimes” (Herman 2008). Essentially, floating exchange rates lead to less foreign currency debt. Floating
exchange rates also induce investors to higher amounts of currency hedging to alleviate the losses that
may come with a domestic currency’s exchange rate risk. Herman ,most importantly, points out that
although a floating exchange rate may induce an unstable, fluctuating exchange rate position, it reduces
the financial vulnerability of emerging economies operating under a fixed exchange rate. He notes that
under fixed exchange rate investors has the “invitation to gamble under the government’s expense”
(Herman 2008). He means investors are able to currency hedge leaving the government with the burden
of acquiring foreign assets to defend the fixed exchange rate’s position. Herman’s paper proves
investors are more prone to hedge currency under a floating exchange rate.
Section III. Applicable Economic Theories & Models
To examine if Mexico’s floating exchange rate has accelerated capital flight, this paper will
model microeconomic investor behavior that leads to the exchange of domestic currency for foreign
currency (currency hedging). This modeling will be beneficial for demonstrating the root economic cause

9. Villanueva 9
behind large scale macroeconomic financial outflows known as capital flight. To demonstrate this
microeconomic investor behavior, this paper will apply Modern Portfolio Theory (MPT) assumptions,
empirical macroeconomic evidence and model the Krugman Investment Function. From the implications
of empirical evidence, this paper will then use the MPT assumptions and Krugman investment function
model to demonstrate the microeconomic behavior of investors that has effected the official exchange
rate.
Modern Portfolio Theory (MPT)
To understand an investor’s microeconomic reasoning for exchanging domestic currency for foreign
currency, the Modern Portfolio Theory (MPT) provides a solid foundation to the theories behind asset
risk management. The Modern Portfolio Theory was first introduced by Henry Markowitz in 1952 as a
critical step to properly managing an individual portfolio or assets (Winthrop Capital Management 2012).
The first aspect of managing one’s assets in MPT is based off maximizing the expected return while
minimizing the variability of asset losses within a market (Winthrop Capital Management 2012). Most
significantly, MPT takes into account managing risk. According to Winthrop Capital Management, “MPT
breaks risk into two parts: systematic risk and unsystematic risk. Systematic risk is the risk inherent in
the market. Unsystematic risk is the idiosyncratic risk that exists with the investment of a particular
security. An important conclusion of MPT is that one can minimize the unsystematic risk through
diversification” (Winthrop Capital Management 2012). However, evading the systematic risk of an asset
is only viable through currency exchange since foreign currencies are only subject to asset losses in their
own domestic market.
MPT’s assumptions of investor behavior rely on five assumptions. In the first one, investors act
rationally by making any optimal decision to maximize profit and minimize losses. In the process of
investor’s acting rationally, there is no friction in the market and capital flows freely between a buyer

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and a seller allowing a free market to operate harmoniously with little regulation(Winthrop Capital
Management 2012). Over the long run, investors consider each investment alternative as being
represented by a probability distribution of expected returns over some holding period(Winthrop Capital
Management 2012). Essentially, investors expect past investment returns to remain consistent for the
future. This expectation is conducive to the momentum effect where an investor may continue to buy,
hold or sell an asset due to its continually falling or rising price over a long period of time. When an
asset is experiencing a momentum effect, there is a positive relationship between risk and
return(Winthrop Capital Management 2012). In the case of domestic assets’ experiencing plunging
exchange rate depreciation, the risk of taking the initiative to hedge currency can yield a positive return.
Lastly, when investors estimate risk1
they anticipate the forecasted asset loss(Winthrop Capital
Management 2012).
Through applying assumptions of the Modern Portfolio Theory to the behavior of Mexican
currency investors, it demonstrates a strategic framework for managing assets in order to evade the
systematic risk inherent to a domestic economy. This investment strategy is critical for understanding
the initiatives behind offsetting asset losses by exchanging domestic currency for foreign currency
(capital flight) (Winthrop Capital Management 2012).
Krugman Investment Function
To analyze domestic asset’s systematic risk under a floating exchange rate, this paper will apply
the Krugman Investment function model. The Krugman Investment Function was developed by Paul
Krugman in order to determine how much investment depends on the official exchange rate (Flaschel
and Semmler 2003). In its application for this paper, the model will serve primarily as a guide to
demonstrating investors’ responsiveness to hedge currency in relation to an exchange rate fluctuation.
1
Modern Portfolio Theory (MPT) taken from Winthrop Capital Management

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Within the Krugman investment function, the swerving cubic curve is a function representing
exchange rate spot position in relation to its exchange rate risk and currency demand. The vertical axis e
represents the exchange rate value. At the intersection of vertical axis e and the swerving cubic curve,
any exchange rate spot position on the cubic curve above the intersection denotes a weakening
currency, and any exchange rate spot position on the cubic curve below the intersection denotes a
strengthening currency.
The horizontal line I represents investment return, and similarly, the vertical axis e connects at
the middle of line I to represent when the exchange rate spot position is experiencing a return on
investment due to currency strengthening or a loss in the return on investment due to a weakening
currency (Flaschel and Semmler 2003). In addition, (-ᵹK) is placed on the far left side of the horizontal
line I to indicate an increasing systematic risk as the currency begins weakening.
The swerving shape of the cubic curve was designed to indicate currency exchange elasticity and
inelasticity. Whether the exchange rate spot position is at, near or around the exchange rate spot
position of “totally depressed investment”
or “supply side bottlenecks,” it indicates
currency exchange is very insensitive or
inelastic2
, and there is little exchange
rate risk. This inelasticity is represented
by the cubic curve’s extremely steepening
slope in these two regions. When
currency exchange is very inelastic, only
2
Flaschel, Peter, and Willi Semmler. "Quantitative and Empirical Analysis of Nonlinear Dynamic Macromodels." Currency Crisis,
financial crisis, and large output loss 277 (2003): 385-414.

12. Villanueva 12
very large exchange rate fluctuations will induce the exchange of domestic assets for foreign assets. On
the other hand, when the exchange rate spot position is near the intersection of the cubic curve and
vertical axis e, currency exchange becomes very elastic as represented by the flattening slope in this
intersection region. When currency exchange is very elastic, it only takes small exchange rate
fluctuations to induce the exchange of foreign assets for domestic assets and vice versa. In these
exchange rate spot positions where currency exchange is very elastic, currency exchange will occur more
rapidly than at positions where currency exchange is more inelastic. As well, these regions where
currency exchange is very elastic also represents high exchange rate risk where exchange rate
fluctuation will translate an increased valuation on domestic assets.
Together, the vertical axis e and horizontal axis I are indicators for investors to know whether or
not to exchange currency. The cubic curve’s inverted slope and intersection at the middle of vertical axis
e illustrates when an exchange rate spot position translates to an asset loss due to increased systematic
risk or an asset gain (Flaschel and Semmler 2003) .
Moving downward along the cubic curve, the investment returns become positive as the
exchange rate spot position strengthens closer to the intersection and moves farther away from the
intersection translating to increasing asset gains (Flaschel and Semmler 2003). On the other hand, by
moving upward along the cubic curve, the investment returns weaken as the exchange rate moves
farther away from the intersection to the left of horizontal axis I denoting negative investment returns
(losses) (Flaschel and Semmler 2003).
One interesting feature within this model is the way it displays the increasing degree of
systematic risk at an exchange rate’s spot position. On the horizontal line I at -ᵹK, as the exchange rate
spot position weakens moving upward along the cubic curve , systematic risk increases (-ᵹK) yielding a
higher incentive to exchange domestic currency for foreign currency to offset any future asset losses
(currency hedge) (Flaschel and Semmler 2003).

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Applying the Krugman investment function model along with the assumptions of the Modern
Portfolio Theory, this paper will model microeconomic investor behavior before demonstrating how
large scale illicit financial outflows are affected by Mexico’s floating exchange rate.
Section IV. Data
Through examining the macroeconomic variables that influence capital flight under a floating
exchange rate, empirical evidence displaying a weakening exchange rate, exchange rate percentage
changes, the rates of inflation, decreasing interest rates and a decreasing risk premium on lending
portray how currency holders are anticipating potential asset losses and losing investor confidence to
continue holding onto domestic Mexican currency. These macroeconomic indicators are necessary
since they are all signals that investors look at for rationally deciding on whether or not to hold onto
domestic assets instead of exchanging for foreign assets to evade asset devaluation. Any trend of a
weakening exchange rate is an automatic indicator for an investor to begin hedging their domestic
assets to foreign assets to evade asset losses. In addition, a decreasing interest rate is also an important
indicator to an investor because it signals whether or not depositing money into domestic banks is
yielding interest rate profit. Similarly, the risk premium for lending indicates to an investor whether or
not lending out their funds within the domestic economy will yield a high risk premium for lending profit.
Together, these macroeconomic variables are indicators to investors that signal whether or not they
should hold onto domestic assets or hedge currency to offset any future losses.

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Empirical Analysis
Annual Illicit financial inflows & licit financial inflows 1970-2011
3
The following graph of annual illicit financial outflows (IFO) and licit financial inflows (LFI) from
1970-2011 displays an increasing disparity between IFOs and LFIs since the implementation of the
floating exchange rate in 1994. For reference, the composition of licit financial inflows is private equity
(inflows) plus net foreign direct investment. The significance of examining this relationship is to illustrate
from a macroeconomic perspective how outflows exceeding inflows by an increasingly large amount are
detrimental to the Mexican domestic supply of money and to any type of strengthening of the official
exchange rate. Theoretically, when capital outflows exceed capital inflows under a floating exchange
rate, they induce a currency devaluation (weakening) since there is an increased supply of domestic
currency within the economy. For currency exchange to occur, investors must exchange domestic assets
for foreign assets. This exchange expands the supply of money and weakens the domestic currency
against other foreign currencies. This increasing trend of capital outflows exceeding capital inflows
provides a possible link to the persistently weakening Mexican official exchange rate since the 1994
implementation of a floating exchange rate.
3
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
0
10
20
30
40
50
60
70
80
90
100
1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
Billions
Licit
financial
inflow
Illicit
financial
outflow

15. Villanueva 15
Mexican Official Exchange Rate 1970-20104
In relation to the IFO/LFI graph, Mexico’s official exchange rate is relative to the increasing disparity
between IFOs and LFIs. Since the 1994 implementation of the floating exchange rate, the official
exchange rate has only weakened annually and now stands at about $13 MXP to $1 USD. The correlation
between LFIs and the Mexican official exchange since 1994 provides further evidence that there may be
a correlation between the two variables.
Mexican exchange rate percentage change 1970-20105
4
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
5
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
0
2
4
6
8
10
12
14
16
Official
exchange
rate (LCU per
US$, period
average)
-160
-140
-120
-100
-80
-60
-40
-20
0
20
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Exchange
rate
percentage
change from
preceding
year

16. Villanueva 16
Examining the percentage changes in the Mexican official exchange rate identifies another
signal to why investors may be led to hedge currency. Although from 1981 to 1989 the graph displays
extremely volatile percentage fluctuations, the currency’s exchange rate remained steadily almost equal
to 1 in the time span. This occurred due to large changes in the exchange rate’s hundredth place.
Furthermore, since the 1994 floating exchange rate transition, Mexico’s official exchange rate
has persistently weakened at an average of 12.5 %. Although graphically percentage change does not
seem volatile, the currency has been consistently weakening every year. This consistent weakening of
the domestic currency is a signal of speculative fear for investors since there is a systematic risk in
holding onto Mexican domestic assets.
Mexican Rate of Inflation 1970-20106
Examining Mexico’s annual rate of inflation raises an interesting inquiry as to how this has
affected investor behavior since the inflation rate has only continued to decrease. Unless this is not a
variable used by investors to evaluate whether or not there is an increased investment risk to holding
domestic currency, decreased inflation should lead investors to hold domestic currency since they will
have a higher amount of purchasing power. However, a low rate of inflation yet increasing amount of
capital flight may imply that there are increased fears and a loss of confidence for investors to hold
domestic currency. This continued fear due to the floating exchange rate’s mechanism to signal its own
6
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
0
50
100
150
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Inflation,
consumer
prices
(annual %)

17. Villanueva 17
currency position increases an investor’s fear of taking on the risk of a highly volatile asset. Investors
may be exchanging for assets denominated in foreign currency out of speculative fear.
Mexican Deposit Interest Rate 1970- 20117
However, through examining the Mexican deposit interest rate, which has been continually
decreasing since 1994, it implies that a decreased interest rate profit and consistently devaluing official
exchange rate are two possible driving forces behind increased illicit financial outflows from Mexico.
This consistently low Mexican deposit interest rate is one important factor to consider that may lead
investors to hedge currency due to bank interest rate profits not returning as equal returns as foreign
banks. A low deposit interest rate profit is a viable reason to search abroad for a higher interest rate
profit.
Mexican Risk Premium on Lending 1970-20118
In addition to Mexico’s low interest rate profit, the risk premium on lending has also been
consistently low since the 1994 adoption of a floating exchange rate. Since the risk premium on lending
is the compensation for tolerating financial risk, the graph below displays how there is a very low
incentive for investing in Mexico’s domestic currency. This macroeconomic variable is a significant
7
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
8
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
0
20
40
60
80
100
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
Mexico MEX
Deposit interest
rate (%)
FR.INR.DPST

18. Villanueva 18
factor that has decreased since the transition to floating exchange rate and is an influential factor to
increased capital flight from Mexico. The combination of a low interest rate profit and risk premium for
lending profit creates a high incentive for investors to hedge currency.
9
Economic Modeling & Discussion
The implications from the empirical evidence signal that Mexican investors have experienced a
higher incentive to hedge currency since the 1994 transition to a floating exchange rate. Both a
consistently weakening exchange rate and a low monetary incentive to hold onto domestic assets prove
that investors are looking abroad for safer financial institutions to store funds. These investors are
looking abroad since illicit financial outflows (capital flight) have been increasing every year since 1994.
The incentives for Mexican investors to hedge seem to be mainly based off speculative fear.
This speculative fear imposes an opportunity cost to investors if they fail to act rationally and hedge
currency. In this opportunity cost, the investor face the explicit costs of holding onto a weakening
domestic currency and storing funds into Mexican financial institutions that yield much lower interest
rate profit and/ or risk premium for lending profit than financial institutions abroad. The implicit cost is
the Mexican investor’s inability to be relieved of her/his speculative fear.
9
Data retrieved March 1, 2012 from World Development Indicators & Global Development Finance Online (WDI &
GDF) database
0
2
4
6
8
10
12
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
Risk premium on
lending (prime
rate minus
treasury bill rate,
%)

19. Villanueva 19
Examining the explicit costs in consideration of the empirical evidence, the average exchange
rate devaluation has been 12.5% every year since 1994. Because of this, investors are facing a high
incentive to hedge their domestic assets for foreign assets in order to prevent the risk of loss due to a
weakening currency. In addition, the investor also faces the explicit cost of storing his funds into
Mexican financial institutions. From empirical evidence, these financial institutions since 1994 have
been yielding very low interest rate profit and risk premium for lending profit. Psychologically, the
Mexican investor also faces the implicit cost of an increasing speculative fear of asset devaluation due to
unfavorable financial conditions of the Mexican economy.
In the case of the Mexican investors, taking up the opportunity to currency hedge is very
beneficial to their financial assets, so they must follow two assumptions of the MPT and estimate the
risk then act rationally. Through exchanging their domestic assets for assets denominated in foreign
currency, the investor will not only have the security of a foreign currency that is less prone to exchange
rate risk, but they also will have the opportunity to place their funds into foreign financial institutions
that may yield a higher interest rate profit, risk premium for lending profit and even less taxation.
Applying the Krugman investment function model, the current exchange rate spot position of
the Mexican peso is marked on the cubic curve with the black dot and is level with the horizontal line
denoting a “totally depressed investment” (Flaschel and Semmler 2003). This point which signals both
currency exchange inelasticity and a “totally depressed investment” does not model current
microeconomic behavior of Mexican investors neither does it reflect the data that points to consistent
levels of capital flight which require currency exchange (Flaschel and Semmler 2003). If this model were
accurate, only large short run exchange rate fluctuations would induce currency exchange due to its
inelastic position on the curve.

20. Villanueva 20
Interestingly, this point is actually the current position of the Mexican currency. What’s unique
about this situation is that the momentum effect is at play. The momentum effect is when an asset
persistently falls or rises in price for a long period of time (Kar 2012). Explaining this sort of phenomenon,
consider the initial exchange rate percentage change after the transition to a floating exchange rate.
That percentage change was 90.2% devaluation from the original fixed exchange rate position (Kar 2012).
Following the 1994 transition to a floating exchange rate, roughly $36.3 billion dollars left Mexico (a 127%
increase from the previous $15.9 billion dollars in 1994) (Kar 2012). Consistently after Mexico’s 90.2%
floating exchange rate devaluation in 1995, the floating exchange rate has persistently devalued since
1994 by 12.5% every year and
illicit financial outflows have
averaged $43.5 billion dollars
with a progressively increasing
upward trend (Kar 2012).
Within the last years since
2006, capital flight has only
increased getting to an all-time
high of $91 billion dollars in
2007 (Kar 2012).
The initial 1995 exchange rate devaluation shock of 90.2% can best be characterized as the
catalyst to the acceleration of capital flight under a floating exchange rate. Depicting this on the graph,
the intersection dot at vertical axis e and the cubic curve represents the initially elastic currency
exchange spot. Since at that position any small exchange rate fluctuation leads to a large increase in
currency exchanging, the huge 90.2% exchange rate devaluation of 1995 and following 12.5% average
devaluation every year has contributed to increased currency hedging that’s turned into a momentum

21. Villanueva 21
effect stimulated by the persistent speculative fear of Mexican investors. This persistent speculative fear
also demonstrates how investors are behaving within the assumptions of the Modern Portfolio Theory.
Investor’s believe they are acting rationally because the exchange rate is devaluing at a substantial rate
yearly. The consistent devaluation allows them to continually anticipate and forecast risk. Because of
this, they take on a high risk investment strategy by currency hedging to offset a loss and receive a
higher return. In combination, by the investor behaving within the confines of the MPT, the momentum
effect is able last longer due to an unrelieved speculative fear.
Section V. Conclusion
Concluding this paper, the floating exchange does accelerate capital flight through the
momentum effect. Because of the floating exchange rate’s mechanism that provides investors with the
exchange rate’s spot position that indicates systematic risk, investors of Mexican domestic currency
have a higher incentive to hedge currency to offset losses with foreign assets. They also have a higher
incentive to eliminate their speculative fears of asset losses. These losses don’t just include the potential
devaluation of the domestic currency, but also, the missed opportunity of storing funds within foreign
financial institutions that provide a much higher monetary gain.
If Mexico were to address the issue of controlling capital flight, a contractionary monetary
policy aimed at either strengthening the official exchange rate or luring both domestic and foreign firms
to store funds into Mexican financial institutions would be the key. In the Mexican peso crisis, it was
proved that Mexico did not have the financial capabilities and neither did they have the trust from
foreign banks to pay back a huge loan that would sustain a fixed exchange rate (Kar 2012). The only
issue with a contractionary monetary policy would be the harmful effects it can bring to economic
expansion due to increased interest rates.
In addition, my paper differs from Herman Kamil’s and Dev Kar’s because it takes a theoretical
approach at proving a floating exchange rate regime accelerates capital flight. However, this paper still

22. Villanueva 22
does not account for other variables that may affect capital flight such as political stability or cultural
influence.
Section VI. Index
Year Official Exchange Rate Percentage Change (%)
1970 0.0125
1971 0.0125 0.00%
1972 0.012500023 0.00%
1973 0.012499952 0.00%
1974 0.012499969 0.00%
1975 0.0125 0.00%
1976 0.01542585 -23.40%
1977 0.022572867 -46.30%
1978 0.022767283 -0.90%
1979 0.022805383 -0.20%
1980 0.022951008 -0.60%
1981 0.0245146 -6.80%
1982 0.0564017 -130.10%
1983 0.120093583 -112.90%
1984 0.167827583 -39.70%
1985 0.256871583 -53.10%
1986 0.611772583 -138.20%
1987 1.3781825 -125.30%
1988 2.273105 -64.90%
1989 2.4614725 -8.30%
1990 2.812599167 -14.30%
1991 3.01843 -7.30%
1992 3.094898333 -2.50%
1993 3.115616667 -3.10%
1994 3.375116667 -8.30%
1995 6.419425 -90.20%
1996 7.599448417 -18.40%
1997 7.91846 -4.20%
1998 9.13604175 -15.40%
1999 9.5603975 -4.60%
2000 9.455558333 1.10%
2001 9.342341667 1.20%
2002 9.655958333 -3.40%
2003 10.78901917 -11.70%
2004 11.28596667 -4.60%
2005 10.89789167 3.40%
2006 10.89924167 0.00%
2007 10.92819167 -0.30%
2008 11.12971667 -1.80%
2009 13.513475 -21.40%
2010 12.63600833 6.50%

23. Villanueva 23
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