In: Finance
The U.S. interest rate is7 percent and the Canadian dollar’s interest rate is 6 percent. The Canadian dollar's forward rate has a premium of 2 percent. (1) Calculate the effective financing rate for U.S. firms. (2) Does interest rate parity hold? (3) Could U.S. firms lock in a lower financing cost by borrowing Canadian dollars and purchasing Canadian dollars forward for one year? Explain. |
Home currency is USD and Foreign Currency is CAD.
According to Interest rate parity:
F/S=(1+Rd)/(1+Rf)
Where F=Forward rate of Foreign Currency
S= Spot rate of Foreign Currency
Rd= Interest rate in home country
Rf= Interest rate in Foreign Country
(1) Calculation of effective finance rate for US firm:
Suppose the current exchange rate USD/CAD=.76
CAD forward rate has premium of 2% hence Forward CAD price shall be=.7752 USD(i.e..76*1.02)
hence, .7752/.76=1+Rd/1+.06
1+Rd=.7752*1.06/.76
1+Rd=.1.0812
Rd=1.0812-1
Rd=.0812 or 8.12%
(2) As the theoretical US interest rate(8.12%) is higher than actual interest rate(7%), Interest rate parity does not hold.
(3)Borrow 1CAD and conver to .76USD.
Invest .76USD at 7% Hence Value of investment after 1 year=.8132(i.e..76*1.07)
After 1 year USD required to repay 1CAD=.7752 While value of USD investment is .8132 hence Gain in USD=.038 (i.e..8132-.7752)
Hence one can make a gain of .038 by borrowing 1CAD.Hence US firm can lock in a lower financing cost by borrowing CAD and purchasing CAD Forward.
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