10. Jacksonville Corp. is a U.S.-based firm that needs $600,000.

It has no business
in Japan but is considering one-year financing with Japanese yen, because the annual
interest rate would be 5 percent versus 9 percent in the United States. Assume that
interest rate parity exists. (Chapter 20, Question 160.

a) Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing
yen one year forward to avoid exchange rate risk? Explain.

ANSWER: If Jacksonville borrows yen and simultaneously purchases yen one year
forward, it will pay a forward premium that will offset the interest rate differential
(given that interest rate parity exists). Based on interest rate parity, the forward
premium is about 3.8%. The effective financing rate would be:

(1 + 5%)(1 + 3.8%) – 1 = about 9%

b) Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the
future spot rate. Determine the expected effective financing rate. Should Jacksonville finance
with Japanese yen? Explain.

ANSWER: If it does not cover the exposure but uses the forward rate
as a forecast, the expected percentage change in the Japanese yen’s
value is about 3.8 percent. Thus, the expected effective financing rate
is 9%. Jacksonville should therefore finance with dollars rather than
Japanese yen, since the expected cost of financing with dollars is not
higher.

c) Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will
appreciate by 5 percent, 3 percent, or 2 percent, and with equal probability of each occurrence.
Use this information to determine the probability distribution of the effective financing rate.
Should Jacksonville finance with Japanese yen? Explain.

ANSWER:

Possible % Change in Effective Financing Rate of JY

Spot Rate of JY if that % Change Occurs Probability
5% (1.05)(1.05) – 1 = 10.25% 33.3%
3% (1.05)(1.03) – 1 = 8.15 33.3%
2% (1.05)(1.02) – 1 = 7.10 33.3%

Given the probability, there is about a 67 percent chance that financing with Japanese
yen will be less costly than financing with dollars. The choice of financing with yen or
dollars in this case is dependent on Jacksonville’s degree of risk aversion.