Question

A U. S. MNC is considering investing $5 million in excess cash in Brazil at an annual interest rate of 45 percent. The U S interest rate is 6 percent. (1) By how much would the Brazilian real have to depreciate to cause such a strategy to backfire? (2) What other factors should the U S company consider before making such an investment?

Answer 1

1)

When the no-arbitrage condition is satisfied without the use of a forward contract to hedge against exposure to exchange rate risk, interest rate parity is said to be uncovered. Risk neutral investors will have no indifference between interest rates in two different countries as the exchange rate will move accordingly to eliminate any profits existing due to difference in interest rates in the two countries.

Here us interest rate is 6% and Brazil interest rate is 45 % . The brazilian real will depreciate against dollar so that there wont be any arbitrage profits.

Amount by which Brazilian real will depreciate = 1.45 / 1.06 - = 1.3679 - 1 = 36.79 %

2) The US company should also look for the following before making the investment.

a) Political risk exists in every nation which makes the return on the investment very risky.

b) High transaction costs as this is cross border transaction and have to comply with various tax and other regulations.

c) Liquidity risk - Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered and this risk is inherent mostly in emerging markets