In: Finance
A NZ firm needs to borrow NZD 10 million for one year. It can
borrow at a local bank at 6% per
annum or it can issue bonds in Singapore denominated in Singapore
dollars at 7% per annum.
The current spot rate of Singapore dollar is 0.94 S$/NZ$ and the
forecasted exchange rate in one
year is 0.97 S$/NZ$.
(a) | Is it cheaper for the NZ firm to borrow in New Zealand or
Singapore? Show your calculations to justify the answer. |
cheaper to borrow in Singapore (3.69%) (show me step by step
please?) (The other is wrong)
(b) | What is the additional risk(s) involved in borrowing in
Singapore? How could the NZ firm mitigate this risk(s) if it decides to borrow in Singapore? |
Solution :
Option 1: Borrow in New Zealand
Borrowing amount : $10,000,000
Interest rate = 6% per annum
Total amount after one year = $10,000,000 * 1.06 = 10,600,000
Option 2: Issue bonds in Singapore denominated in Singapore dollars at 7% per annum
Current spot rate = 0.94 S$/NZ$
10,000,000 in New Zeland dollar will be equivalent to 10,000,000 * 0.94 S$/NZ$ = 9,400,000 Singapore dollar
interest rate = 7%
Total amount in Singapore dolllar in 1 year = 9,400,000 * 1.07 = 10,058,000
Forecasted exchange rate after one year = 0.97 S$/NZ$
Total amount in NZ dollar = amount in singapore dollar / exchange rate = 10,058,000 / 0.97 = 10,369,072
So difference of these two options = Option 1 - option 2 = 10,600,000 - 10,369,072 = 230,928
So , it is cheaper to borrow in singapore by $230,928 NZ
In percentage terms 230,928 / 10,000,000 = 2.31%
Part B )
Addition risk:
Exchange rate risk : If singapore dollar strengthens as compared to NZ dollar then the advantage of borrowing will be gone
Example: If exchange rate remains the same at 0.94 S$/NZ$ then 10,058,000 singapore dollars will be equivalent to 10,0580,000/ 0.94 = 10,700,000
So it will be costtlier to raise money in singapore dollar
How to mitigate:
in order to keep exchange rate risk contained one can hedge by future contracts or option contracts
Buy call options or go long in the future contracts