Question

Projecta Inc. is a Japanese manufacturer of projectors and audio equipment for cinemas and music theatres across Asia. Projecta Inc. has recently begun implementing its expansion strategy into Europe. To fund working capital for this expansion, Projecta Inc. needs €8,000,000 Euro (EUR) for nine months. The company can either borrow the €8.0m Euro in Paris at 3.5% p.a., or borrow the equivalent of €8.0m Japanese Yen (JPY) in Tokyo at an interest rate of 1.5% p.a. The current spot exchange rate is 120.85JPY /EUR. The expected spot exchange rate in nine months is forecast to be 119.75JPY /EUR. Assume all interest and principal repayments are made at the end of the nine months at the expected exchange rate.

Required:

1. In which currency should Projecta Inc. borrow the money from to realise the lowest borrowing cost?
2. In nine months when the loan is settled, what would the JPY /1EUR spot exchange rate have to be where Projecta Inc. is indifferent between borrowing Japanese Yen and borrowing Euros?
3. Name and describe one instrument that Projecta Inc. could use as a hedge to reduce foreign exchange rate risk in nine months when they repay their loan?

Answer 1

	Given details:
	Projecta Inc. needs €8,000,000 Euro (EUR) for nine months.
	Options company has
(i)	borrow the €8.0m Euro in Paris at 3.5% p.a.,
(ii)	borrow the equivalent of €8.0m Japanese Yen (JPY) in Tokyo at an interest rate of 1.5% p.a.
	current spot exchange rate is 120.85JPY /EUR
	expected spot exchange rate in nine months is forecast to be 119.75JPY /EUR
	Requirement
A.	In which currency should Projecta Inc. borrow the money from to realise the lowest borrowing cost?
(i)	Borrowing cost if the loan is borrowed in Paris
	Borrowing cost = Loan borrowed * Interest rate * Time period
	Borrowing cost = Euro 8,000,000 * 3.5% * 9/12
	Borrowing cost = Euro 210,000
(ii)	Borrow the equivalent of €8.0m Japanese Yen (JPY) in Tokyo at an interest rate of 1.5% p.a.
	Given Current spot exchange rate is 120.85JPY /EUR
	JPY equivalent to Euro 8,000,000 is JPY 966,800,000 (120.85*Euro 8,000,000)
	Borrowing cost = Loan borrowed * Interest rate * Time period
	Borrowing cost = JPY 966,800,000 * 1.5% * 9/12
	Borrowing cost = JPY 10,876,500
	Given expected spot exchange rate in nine months is forecast to be 119.75JPY /EUR
	Therefore, Borrowing cost in Euro = JPY 10,876,500/119.75 = Euro 90,827
	Since the borrowing cost is less in second option, Projecta Inc. shall borrow money in JPY from Tokyo
B.	In nine months when the loan is settled, what would the JPY /1EUR spot exchange rate have to be where Projecta Inc. is indifferent between borrowing Japanese Yen and borrowing Euros?
	Projecta Inc. is indifferent between borrowing Japanese Yen and borrowing Euros if borrowing cost at Paris = borrowing cost at Tokyo
	i.e., Euro 210,000 = JPY 10,876,500
	Therefore, Spot exchange rate after 9 months to be = JPY 10,876,500/Euro 210,000 = JPY 51.79/Euro
C.	Name and describe one instrument that Projecta Inc. could use as a hedge to reduce foreign exchange rate risk in nine months when they repay their loan?
	Projecta Inc. could use "Forward rates" or "Futures" to reduce exchange rate risks