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Chapter 21

Q. 21.FSE.16

Austin Co. needs to borrow $10 million for the next year to support its U.S. operations. It can borrow U.S. dollars at 7 percent or Japanese yen at 1 percent. It has no other cash flows in Japanese yen. Assume that interest rate parity holds, so the one-year forward rate of the yen exhibits a premium in this case. Austin expects that the spot rate of the yen will appreciate but not as much as suggested by the one-year forward rate of the yen.
a. Should Austin consider financing with yen and simultaneously purchasing yen one year forward to cover its position? Explain.
b. If Austin finances with yen without covering this position, is the effective financing rate expected to be above, below, or equal to the Japanese interest rate of 1 percent?
Is the effective financing rate expected to be above, below, or equal to the U.S. interest rate of 7 percent?
c. Explain the implications if Austin finances with yen without covering its position, and the future spot rate of the yen in one year turns out to be higher than today’s one-year forward rate on the yen.

Step-by-Step

Verified Solution

a. Austin should not consider financing with yen and simultaneously purchasing yen one year forward since the effective financing rate would be 7 percent, the same as the financing rate in the United States.
b. If Austin finances with yen without covering this position, its effective financing rate is expected to exceed the interest rate on the yen because of the expected appreciation of the yen over the financing period. However, the effective financing rate is not expected to be as high as the interest rate on the dollar.
c. If the yen’s spot rate in one year is higher than today’s forward rate, the effective financing rate will be higher than the U.S. interest rate of 7 percent.