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 5 percent versus 9 percent in the United States. Assume that interest rate parity exists.
1. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one year forward to avoid exchange rate risk? Explain.
2. 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.
3. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will appreciate by either 5 percent, 3 percent, or 2 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

Jacksonville can't benefit because interest rate parity exists as given in the question. According to interest rate parity, the differential in interest rates between 2 countries is equal to difference in spot exchange rate and foreign exchange rate between them. This happens because if one country will offer high interest rate than other, then people in lower interest rate country will like to invest in higher interest rate country and purchase one year forward exchange rate to book profits in their own country. This will push up the prices of forward exchange rate such that the forward exchange rate will get more expensive by the same interest rate diffrential between countries and the arbitrage is removed.

Therefore, If he borrows in Japan at 5% then he saves 4% interest by doing so. But, the forward exchange rate to convert Japanes Yen in USD will be 4% higher than spot exchange rate. So, this 4% benefit will be removed. So, overall there will be no benefit.