Analysis of Short-term Financing. Montana Airlines is a U.S. based firm that nee

Question

Analysis of Short-term Financing. Montana Airlines is a U.S. based firm that needs $750,000. It has no business in England but is considering one year financing with British pounds, because the annual interest rate would be 4 percent versus 8 percent in the United States. Assume that interest rate parity exists. Assume that Montana Airlines does not cover its exposure and expects that the British pound will appreciate by 6 percent, 4 percent, or 2 percent, and with an equal probability of each. Use this information to determine the probability distribution of the effective financing rate. What is the probability of financing with the British pound will be less expensive? Analysis of Short-term Financing. Montana Airlines is a U.S. based firm that needs $750,000. It has no business in England but is considering one year financing with British pounds, because the annual interest rate would be 4 percent versus 8 percent in the United States. Assume that interest rate parity exists. Assume that Montana Airlines does not cover its exposure and expects that the British pound will appreciate by 6 percent, 4 percent, or 2 percent, and with an equal probability of each. Use this information to determine the probability distribution of the effective financing rate. What is the probability of financing with the British pound will be less expensive?

Explanation / Answer

Answer:

Given the probability, there is about a 67 percent chance that financing with British pounds will be less costly than financing with dollars. The choice of financing with british pounds or dollars in this case is dependent on Montana Airline’s degree of risk aversion.

Possible % change in spot rate of British pounds Effective Financing Rate of British pounds if that percentage change occurs Probability 6% (1.04)(1.06)-1=10.24% 33.30% 4% (1.04)(1.04)-1=8.16% 33.30% 2% (1.04)(1.02)-1=6.08% 33.30%

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