Question

Your firm needs to borrow the equivalent of $10,000,000. The rates at which you can borrow in various countries are:

US: 7% UK: 5% Europe: 8% Japan: 3%

a) If the IFE holds and you were not going to hedge your exchange rate risk, from where would you prefer to borrow and why? (4 points)

b) If IRP holds and you were to hedge your exchange rate risk, from where would you prefer to borrow and why? (4 points)

Answer 1

The International Fisher Effect (IFE) suggests that the changes in the interest rates reflect the changes in anticipated inflation rates and the interest rate differentials provide an unbiased predictor of future changes in spot exchange rates.

The IFE is expressed as a formula as -

  

where i_h and r_h respectively denote the interest and inflation rates for the home currency, whilei_f and r_f respectively denote the interest and inflation rates for the foriegn currency.

Further, the Fisher Effect proposes that the nominal (money) interest rate in a country is equal to the real interest rate times the inflation rate, which means that the real interest rate is equal to the nominal rate of interest divided by the rate of inflation. Generally the interest rates quoted by the lenders are the nominal interest rates, that take into account the possible inflation.

Hence, assuming that -

1. The interest rates quoted are the nominal interest rates

2. The USD to be home currency

3. Inflation rate in the US to be 1.81% for the year 2019 (as per https://www.statista.com)

we compute the corresponding rates for the other countries as below -

Country	Money Interest rates (m)	Inflation rates ('r)	I+m	I+r	1+i = (1+m)/(1+r)	Real Interest rates (i)
US	7.00%	1.81%	1.07000	1.01810	1.05098	5.10%
UK	5.00%	2.53%	1.05000	1.02534	1.02405	2.41%
Europe	8.00%	1.58%	1.08000	1.01584	1.06316	6.32%
Japan	3.00%	4.22%	1.03000	1.04223	0.98826	-1.17%

'Inflation rates computed as per IFE formula stated above

Thus, since the real interest rates in Japan are the negative, that is the lender is likely to bear a greater cost of the loan, the firm should borrow in Japan, if it is not going to hedge exchange rate risk and accepts the IFE to hold true.

The Interest rate parity theory (IRP) implies that the higher interest rate in a country will be offset by a depreciation in the currency of that country. This means, if the IRP holds, the USD will appreciate against the EUR and depreciate against the GBP and the JPY. Hence if a borrowing is made in EUR, there will be a greater liability on the firm to repay, since the appreciation of the domestic currency (USD) will raise the value of the debt instrument denominated in that currency. Thus, yet again, the firm should borrow from the Japanese or European markets, in order to take advantage of the USD depreciation in these two countries. Of these, since Japan has the lower interest rate, it should be the first choice.