A U.S.-based company, Stewart, Inc., arranged a 2-year loan to fund an explorato

Question

A U.S.-based company, Stewart, Inc., arranged a 2-year loan to fund an exploratory project in Mexico. The $1 million loan was funded in Mexico and is denominated in Mexican pesos. It carries a 10.0% nominal interest rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar. Before the first payment came due, however, the exchange rate changed to 5.10 pesos per dollar and remained at that level through the end of the loan period. The loan was not hedged in the foreign exchange market. Thus, Stewart must convert U.S. funds to Mexican pesos to make its payments. What effective annual interest rate will Stewart end up paying on the loan?

17.4%

20.0%

11.5%

21.8%

10.3%

17.4%

20.0%

11.5%

21.8%

10.3%

Explanation / Answer

Annual interest rate due to change in exchange rate = 10% * 5.75 / 5.10

= 11.27%

Effective annual rate = [(1 + 11.27%/2)2 - 1] * 100%

= 11.5% which is option (c)

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