An Australian firm wishes to invest USD100 000 for a year. U.S. interest rates are 0.5%. The AUD/ USD rate at the time of the investment is 1.1000 and at maturity is expected to be 1.2000. Calculate the effective financing rate.

Question

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The effective financing rate can be calculated by considering both the interest earned and the effect of currency exchange rate changes. Initially, the firm invests USD 100,000, which at an interest rate of 0.5% would grow to USD 100,500 after one year. However, due to the expected change in the AUD/USD exchange rate from 1.1000 to 1.2000, the value of the investment in AUD terms would decrease when converted back. Initially, USD 100,000 converts to AUD 110,000 (100,000 * 1.1000). At maturity, to convert USD 100,500 back to AUD at the new rate of 1.2000, you get approximately AUD 83,750 (100,500 / 1.2000). The effective financing rate is calculated by comparing the final amount in AUD to the initial AUD amount, showing a decrease, which when calculated correctly, results in an effective rate of +9.64% pa, taking into account the negative impact of the currency depreciation on the investment's value in AUD terms.

An Australian Firm Wishes to Invest USD100 000 for a Year