Question

A U.S.-based company, American Construction, Inc., arranged a 2-year, $1,000,000 loan to fund a project in Mexico. The loan is denominated in Mexican pesos, carries a 10.0% nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.15 pesos per dollar before the first payment came due. The loan was not hedged in the foreign exchange market. Thus, Stewart must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.15 pesos per dollar through the end of the loan period, what nominal interest rate will Stewart end up paying on the loan?

Answer 1

Foreign Exchange and Interest Rate

Exchange Rate at the time of Loan = 5.75 Mexican Pesos/Dollar

Exchange Rate at the time of loan repayment period = 5.15 Mexican Pesos/Dollar

Appreciation in Mexican Pesos Currency will mean depreciation of Dollar.

So the US-Based Company will end up paying more Interest.

Note - The question requires equal semi-annual payments. It is not clear whether equal payments are for installment amount or principal amount. So the question has been with both the approaches.

Approach 1 = Taking 4 equal Installment Amounts of 1,621,568 Mexican Pesos

Nominal Interest Rate on loan in Dollar = 14.30%

Nominal Interest Rate on loan in Mexican Pesos = 12.80%

Approach 2 = Taking 4 equal principal repayment amounts of 1,437,500 Mexican Pesos

Nominal Interest Rate on loan in Dollar = 13.96%

Nominal Interest Rate on loan in Mexican Pesos = 12.50%

For detailed workings, refer the screenshots below.

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