Question

Jacksonville Corp. is a U.S.‑based firm that needs $500,000. It has no business in Japan but is considering one‑year financing with Japanese yen, because the annual interest rate would be 3 percent versus 5 percent in the United States. Assume that interest rate parity exists.

a) Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one year forward to avoid exchange rate risk? Explain.

b) Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the future spot rate. Determine the expected effective financing rate. Should Jacksonville finance with Japanese yen? Explain.

c) Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will appreciate by either 3 percent, 2 percent, or 1 percent, and with equal probability of each occurrence. Use this information to determine the probability distribution of the effective financing rate. Should Jacksonville finance with Japanese yen? Explain.

Answer 1

1) By borrowing japanese yen and simultaneously purchasing yen one year forward to avoid exchange rate risk, Jacksonville will be benefited by interest rate differential as interest rate parity exists in the market.

(1+0.05)*(1+0.03) -1 = 0.0815 or 8.15%

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2) If Jacksonville does not cover its exposure and uses the forward rate to forecast the future spot rate then expected effective financing rate will be 8.15% as calculated above mentioned. He will benefited with dollars rather than yen to get better financing options. The cost of financing with yen will be higher than dollars.

3) According to question stated above as japanese yen appreciated by 3%, 2% or 1% and with equal probability of each occurrence., The effective financing rate will beas follows;

(1+0.03)*(1+0.03) -1 = 6%

(1+0.03)*(1+0.02) - 1 = 5%

(1+0.03)*(1+0.01) - 1 =4%

As calculatedabove chances of profit occurrence will be higher in case of dollar as compare to yen. Cost of dollar w.r.t japanese yen will be lower and 2 rates are more than that of 5% with 66% chance of probability of this incident could happen.