Question

Consider the situation of firm A and firm B. The current exchange rate is $1.50/€. Firm A is a U.S. MNC and wants to borrow €40 million for 2 years. Firm B is a French MNC and wants to borrow $60 million for 2 years. Their borrowing opportunities are as shown; both firms have AAA credit ratings. $ A $ 7% € 6% B $ 8% € 5% If firm A could use the forward exchange markets to redenominate a 2-year $60m 7 percent USD loan into a 2-year euro denominated loan, what would be the interest rate?

Answer 1

Forward Rate at Year 1 = 1.50 * 1.07 / 1.05 = $1.5286/Euro

Forward Rate at Year 2 = 1.50 * 1.07^2 / 1.05^2 = $1.5577/Euro

1. Firm A borrows $60m today and converts it into Euro at $1.50/Euro = €40m

2. Firm A will enter a 1-year forward contract to buy Dollars by using Euro to service the loan

3. by using 1-year forward rate of $1.5268, Interest Cost of loan = 0.07 × $60m × €1.00/$1.5268 = €2,747,663.55 in one year.

4. Firm A will also enter into a 2-year forward contract to buy Dollars by using Euro to service the loan

5. At the 2-year forward rate of $1.5577, Total cost = 1.07 × $60m × €1.00/$1.5577 = €41,214,953.27 at the end of the second year