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?
As per International Fisher Effect
Exchange rate after one year = Spot rate * ( 1+ interest rate in Dollars)/(1+ interest rate in 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%
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