An Australian firm borrowed USD100 000 for a year. U.S. interest rates were 1.25/1.75%. The AUD/ USD rate at the time of borrowing was 1.5400/600 and at maturity was expected to be 1.8624/864. Calculate the effective financing rate.

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The effective financing rate can be calculated by considering both the interest costs and the impact of exchange rate changes on the repayment amount. Initially, the firm borrows USD 100,000, which at an interest rate of 1.75% (the higher rate is applicable for borrowing) would amount to a total repayment of USD 101,750 after one year. The initial exchange rate for borrowing is 1.5400 (the higher rate is applicable for buying USD), so the initial AUD cost is USD 100,000 * 1.5400 = AUD 154,000. At maturity, the expected exchange rate is 1.8624 (the lower rate is applicable for selling USD to convert back to AUD), so the AUD cost of repaying USD 101,750 is USD 101,750 * 1.8624 = AUD 189,496.24. The effective financing rate in AUD terms is then (AUD 189,496.24 - AUD 154,000) / AUD 154,000 = 0.2249 or 22.49% per annum.

An Australian Firm Borrowed USD100 000 for a Year