An Australian company wishes to borrow AUD1 000 000 for ten years. The ten-year bond rate in the U.K. is 3.50% and in Australia is 5.3%. The AUD/GBP spot rate is 2.5000 and the estimated spot rate at maturity is 2.8000. In what currency will a risk neutral firm denominate its bonds?

Question

Quizplus · Accepted Answer

A risk-neutral firm will choose the currency that minimizes its expected cost of borrowing. By borrowing in U.K. pounds, the firm can benefit from the lower interest rate (3.50% vs. 5.3%). Additionally, if the AUD depreciates against the GBP (as suggested by the expected spot rate moving from 2.5000 to 2.8000), the cost of repaying the loan in GBP will be lower when converted back to AUD, further reducing the cost of borrowing.

An Australian Company Wishes to Borrow AUD1 000 000 for Ten