Assume that interest rate parity holds between the United States and Japan. The U.S. one-year interest rate is 7 percent, and Japan's one-year interest rate is 6 percent. What is the approximate effective financing rate of a one-year loan denominated in Japanese yen assuming that the MNC covered its exposure by purchasing yen one year forward?

Question

Quizplus · Accepted Answer

According to interest rate parity, the difference in interest rates between two countries should be reflected in the forward exchange rate. In this case, since the U.S. interest rate is higher than Japan's, the forward exchange rate should reflect a depreciation of the dollar against the yen to compensate for the higher interest rate. Therefore, by borrowing in yen and converting it forward, the MNC would pay an effective financing rate equal to Japan's interest rate plus any forward premium. Since there is no information given about the forward premium, we can assume it to be zero. Thus, the approximate effective financing rate would be 6% (Japan's interest rate).

Assume That Interest Rate Parity Holds Between the United States