Question

You are working for a company in US and your boss said “we are paying about 4% to borrow dollars for one year, but we could get a one-year yen loan for about 3%. Why don’t we repay our dollar loans and borrow yen instead?” How should you respond suppose the spot rate is 100yen/$ and 1-year forward rate is 95yen/$?

Answer 1

One-year yen loan is about 3% compared to 4% to borrow dollars for one year.

Lets do a comparison , borrow in Yen, Assume 100 yen and convert to 1$ and use the proceeds

after one year pay interest @ 3% , 100 *.03 = 3 Yen + 100 Yen (Principal) = Total of 103 Yen

Convert dollars to Yen to repay the loan.

1.0842 dollars required to convert it in to 103 Yen at one year forward rate( 95yen/$).

Hence,

total cost in term of dolllars when borrowed in Yen = 1.0842

total cost when borrowed in dollar = 1 * .04 = 1.04

Net cost = 0.0442

0.0442$ cost more for the yen loan because dollar depriciated and Yen appreciated in the one year course.

Hence if the reliability of forecast of forward rate is accurate, then borrowing in dollar costs less than borrowing in Yen eventhough interest rate on yen loan is less. Fluctuaiton in currencies wiped off the borowing cost differences.