ALFRED BROOKS MENSWEAR, LTD
1. US Prime rate = 11%
2. CDN Prime = 12.75%
3. Actual 6 month forward rate = C$1.1940/US
Using numbers in case:
A. Invest for 6 months Netinflow US$ 6,555 @ 11%/2 = US$ 6,916
a. Convert to C$ now US$6,555 * C$1.1858/US$ = C$ 7,773
b. Invest for 6 months C$7,773 @ 12.75% /2 = C$8,268
c. What 6 monthrate would you be indifferent to converting at: C$6,916*x = 8,268
d. x = 8,268/6,916 = C$1.196/US$
( 1 + i US)
BORROW U$SELL U$ S C$/U$ BUY U$ SELL U$ F C$/U$ BUY U$
SPOT SPOT FORWARD FORWARD
(1 + iCD)
BORROW C$No money making, hence:
Interest Rate Parity Rule:
F C$/U$ = SC$/U$ * (1 + iCDN)/(1 + iUS)
FC$/U$ = forward rate of C$ in U$ (e.g. 1.1940) SC$/U$ = spot rate of C$ in U$ (e.g.1.1858) iCDN = interest rate in Canada on C$ iUS = interest rate in U.S. on U$
Assumption: (1) no commissions
2) no bid-ask spread2) borrowing/lending rates are equal
3) no tax differences
4) no foreign currency restrictions
ALFRED BROOKS, LTD
WHAT DO WE LEARN?
1.Important interaction between financing issues/working capital issues (A/R and A/P) and risk management
2. Identifies the risks that a company undertakes when it engages in international trade
3.Introduces foreign currency loans and futures contracts as some of the vehicles to manage risks
4. Introduces the relationship between the spot, forward, domestic and foreign lending rate.
CurrencyForward rate example (from Grinblatt and Titman, Financial Markets and Corporate Strategy, pg. 231)
Compare the riskless future payoffs of two strategies that buy 1USD today.
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