Smart Banking Corp. can borrow $5 million at 6 per cent annualized. It can use the proceeds to invest in Canadian dollars at 9 percent annualized over a six-day period. The Canadian dollar is worth $.95 and is expected to be worth $.94 in six days. Based on this information, should Smart Banking Corp. borrow U.S. dollars and invest in Canadian
dollars? What would be the gain or loss in U.S. dollars?
Smart Banking Corp. should not pursue the strategy because a loss would result, as shown here.
a. Borrow $5 million.
b. Convert $5 million to C$5,263,158 (based on the spot exchange rate of $.95 per C$).
c. Invest the C$ at 9 percent annualized, which represents a return of .15 percent over 6 days, so the C$ received after 6 days = C$5,271,053 (computed as C$5,263,158 × [1 + .0015]).
d. Convert the C$ received back to U.S. dollars after 6 days: C$5,271,053 = $4,954,789 (based on anticipated exchange rate of $.94 per C$ after 6 days).
e. The interest rate owed on the U.S. dollar loan is .10 percent over the 6-day period. Thus, the amount owed as a result of the loan is $5,005,000 [computed
as $5,000,000 × (1 + .001)].
f. The strategy is expected to cause a gain of $4,954,789 – $5,005,000 = -$50,211.