Madison Finance Inc., has borrowed £75,000 at an interest rate of 5% to be repaid in one year. If the current spot rate is $1.90/£ and the pound appreciates in value against the U.S. dollar by 2% over the next year, what is the effective cost of this loan to Madison?

Question

Quizplus · Accepted Answer

The effective cost of the loan includes both the interest rate and the change in exchange rate. The pound appreciates by 2%, so the new exchange rate is $1.90 * 1.02 = $1.938/£. The loan repayment in pounds is £75,000 * 1.05 = £78,750. In dollars, this is £78,750 * $1.938 = $152,662.50. The initial loan amount in dollars was £75,000 * $1.90 = $142,500. The effective cost is ($152,662.50 - $142,500) / $142,500 = 7.10%.