A U.S.-based company, Stewart, Inc., arranged a 2-year, $1,000,000 loan to fund a project in Mexico.The loan is denominated in Mexican pesos, carries a 10.0% nominal rate, and requires equal semiannual payments.The exchange rate at the time of the loan was 5.75 pesos per dollar, but it dropped to 5.10 pesos per dollar before the first payment came due.The loan was not hedged in the foreign exchange market.Thus, Stewart must convert U.S.funds to Mexican pesos to make its payments.If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective interest rate will Stewart end up paying on the loan?
A) 10.36%
B) 11.50%
C) 17.44%
D) 20.00%
E) 21.79%

Question

Quizplus · Accepted Answer

1. Calculate the amount of the loan in pesos: 1,000,000 x 5.75 = 5,750,000 pesos
2. Calculate the semiannual payment in pesos: 5,750,000 / 4 = 1,437,500 pesos
3. Calculate the semiannual payment in dollars at the original exchange rate: 1,437,500 / 5.75 = $250,000
4. Calculate the semiannual payment in dollars at the current exchange rate: 1,437,500 / 5.10 = $282,353. This is the amount that Stewart needs to pay each period in dollars.
5. Calculate the effective interest rate based on the actual payments made: 
PV = $1,000,000
PMT = -$282,353
n = 4
FV = 0
Solve for I/Y = 10.895%
The effective interest rate is therefore 10.895% or 21.79% per annum. The correct answer is E.

A US-Based Company, Stewart, Inc