Question

In: Finance

The U.S. interest rate is7 percent and the Canadian dollar’s interest rate is 6 percent. The...

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.

Expert Solution

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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Feel free to ask any query via comments.

Good Luck!

jeff jeffy answered 7 months ago

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