Question

Gulliver Travel Agencies thinks interest rates in Europe are low. The firm borrows euros at 15 percent for one year. During this time period the dollar falls 19 percent against the euro. What is the effective interest rate on the loan for one year? (Consider the 19 percent fall in the value of the dollar as well as the interest payment.) (Compute your answer from a U.S. perspective. Input your answer as a whole percent.)

Effective Interest Rate %

Answer 1

Answer - Effective interest rate = 34%

Explaination -

Borrowing money from a foreign country being attracted by low interest rates is a risky task, especially if the foreign exchange fluctuations between the currencies of two country faces a lot of fluctuations.

When a company borrows money from another country, it may also need to face the losses if the domestic currency falls against foreign currency which also decreases the foreign exchange value of interest to be paid. In this case the company will have to pay higher number of domestic currency to compensate the fall in domestic currency value as well.

Effective interest rate here becomes the total of Borrowing rate added with the declined rate of dollar value against euro causing loss to the US firm.

So, the effective interest rate = 15% + 19% = 34%