XYZ Co. needs to borrow 100 units of country L money, where the interest rate wo

Question

XYZ Co. needs to borrow 100 units of country L money, where the interest rate would be equal to 10% (‘ = 10%) Alternatively, XYZ can borrow in country F, where the interest rate would be equal to 12.75% (if = 12.75%). The current exchange rate (eo) between countries L and F is (CF / CL) = 10, where CF and CL represent equivalent amounts of currency of countries F and L respectively. In other words, one unit of country L currency is equivalent to ten units of country F currency. The loan will be repaid in one year. The uncertainty about the exchange rate next year is expressed as a uniformly distributed random variable (e1) with a lower limit of 95 and an upper limit of 10.5. What is the probability (pr) that XYZ will be better off by borrowing in country F rather than country L? Justify your answer.

Explanation / Answer

If we borrow from 100 units from L, we pay back 110 units.If we borrow from F, we need to borrow 1000 units in F’s currency and pay back1,127.5.This is equal to 118.68 in L’s currency at e1=9.5 which happens with probability 0.40And is equal to 107.38 in L’s currency at e1=10.5 which happens with probability 0.20This is equal to 102.5 in L’s currency at e1=11 which happens with probability 0.40The last two cases indicate a better deal than borrowing from country L.Hence, XYZ will be better off by borrowing in country F rather than country L withprobability 0.20+0.40 = 0.60

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