ALFRED BROOKS MENSWEAR, LTD

EXAMPLE 1. US Prime rate = 11% 2. CDN Prime = 12.75% 3. Actual 6 month forward rate = C$1.1940/US
Using numbers in case: A. Invest for 6 months Net inflow US$ 6,555 @ 11%/2 = US$ 6,916 or, B. 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 month rate would you be indifferent to converting at: C$6,916*x = 8,268 d. x = 8,268/6,916 = C$1.196/US$

An Illustration

LEND U$

( 1 + i US)

BORROW U$

SELL U$ S C$/U$ BUY U$ SELL U$ F C$/U$ BUY U$ SPOT SPOT FORWARD FORWARD

LEND C$

(1 + iCD)

BORROW C$

No money making, hence:

Interest Rate Parity Rule:

F C$/U$ = SC$/U$ * (1 + iCDN)/(1 + iUS) where: 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 spread 2) borrowing/lending rates are equal 3) no tax differences 4) no foreign currency restrictions

S w

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.

Currency Forward 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.
Suppose
1. 1USD =