Question

The U. S. interest rate is 8 percent and the euro’s interest rate is 5 percent. The euro’s forward rate has a premium of 4 percent. (1) Calculate the effective financing rate for U S firms. (2) Does interest rate parity hold? (3) Could U S firms lock in a lower financing cost by borrowing euros and purchasing euros forward for one year? Explain

Answer 1

1). Effective financing rate if financing with euro = (1+euro interest rate)(1+euro premium) - 1

=(1+5%)(1+4%) - 1 = 9.2%

Effective financing rate if financing with dollar = 8%

2). In this case, interest rate parity does not hold otherwise the interest rate differential of 9.2% - 8% = 1.2% would be offset by the forward premium which is not happening here.

3). Interest rate differential = 9.2% - 8% = 1.2%

For the US firms to be able to lock in a lower financing cost by borrowing euros and purchasing euros forward for one year, the forward premium on euro has to be lower than this interest differential. This is not the case here, so US firms cannot lock in a lower financing cost, using this strategy.