Question

Luca Electron is an electronic billboard manufacturer that specialises in manufacturing and installing billboards in sporting arenas across Asia. To fund working capital, Luca Electron needs $5,000,000 AUD for six months. The company can either borrow the $5m Australian dollars in Sydney at 6.0% p.a., or borrow the equivalent of $5m AUD in Euro’s at an interest rate of 2.5% p.a. and current spot exchange rate of 1.5623AUD /EUR. The expected spot exchange rate in six months is forecast to be 1.6055AUD /EUR. Assume all interest and principal repayments are made at the end of the six months at the expected exchange rate.

1. In which currency should Luca Electron borrow the money from to realise the lowest borrowing cost?
2. In six months when the loan is settled, what would the AUD/ 1EUR spot exchange rate have to be where Luca Electron is indifferent between borrowing Australian dollars and borrowing Euros?
3. If Luca Electron decides not to use a hedge, what risk does Luca Electron face by relying on the unhedged expected exchange rate in six months when they repay their loan?

Answer 1

After six months AUD/ 1EUR spot exchange rate to be where Luca Electron is indifferent between borrowing Australian dollars and borrowing Euros:

Current spot exchange rate:1.5623AUD/EUR

Australia interest rate for six months=(6/2)%=3%=0.03

Euro interest rate for six months=(2.5/2)%=1.25%=0.0125

Future Value of 1.5623 AUD after six month=1.5623*(1+0.03)=1.609169AUD

Future Value of 1 EURO  after six month=1*(1+0.0125)=1.0125EURO

INDIFFERENT exchange rate after six months: 1.609169AUD=1.0125EURO

(1.609169/1.0125)AUD/EURO=1.5893AUD/EURO

Expected spot exchange rate in six months is forecast to be 1.6055AUD/EURO

Expected exchange rate is higher. EURO will be costlier than idifferent rate after six month.

If it borrows in AUD amount repayable after 6 months =5million*1.03=5.15million AUD

If it borrows in EURO: Amount to be borrowed=(5/1.5623) million EURO=3.20041 EURO

Amount repayable after 6 months=3.20041*(1.0125) EURO=3.240415EURO

Amount repayable in AUD=3.240415*1.6055=5.202486 Million AUD

IT SHOULD BORROW IN AUD.