Question

On a particular day, an American company, Company A, borrows euro-denominated funds for one year at 1.50%. In comparison, a similarly rated U.S. company, Company B, borrows a dollar loan with the same maturity at 3.00%. The exchange rate on the borrowing date is $1.1200/€. Assume that the international Fisher effect holds true. What is the expected effective cost of debt in dollars (in percentage) for Company A?

Answer 1

As per International Fisher Effect

Exchange rate after one year = Spot rate * ( 1+ interest rate in Dollars)/(1+ interest rate in Euro)

=1.12*1.03/1.015

=$1.136552/Euro

Now, if Euro 100 ($112) is borrowed by company A, then after one year   , Euro 101.5 has to be returned

Amount of dollar to be returned = 101.50*1.136552 = $115.36

In terms of Dollar, the company A took a loan of $112 and returned $115.36 , thereby paying an interest = $3.36

So, effective cost of debt in dollars = 3.36/112 = 0.03 or 3%

So, the expected effective cost of debt in dollars (in percentage) for Company A is 3%