Consider the situation of firm A and firm B. The current exchange rate is $2.00/£ Firm A is a U.S. MNC and wants to borrow £30 million for 2 years. Firm B is a British MNC and wants to borrow $60 million for 2 years. Their borrowing opportunities are as shown, both firms have AAA credit ratings. $ £A$6% £5%B$7% £4%Explain how firm A could use the forward exchange markets to redenominate a 2-year $60m 6 percent USD loan into a 2-year pound denominated loan.
What will be an ideal response?
Firm A could borrow $60m today and exchange for £30m at today's spot rate. Then they could enter a 1-year forward contract on euro agreeing to buy enough dollars with pounds to service their loan. At the 1-year forward rate of $2.0385/£ this will cost 0.06 × $60m × £1.00/$2.0385 = £1,766,037.74 in one year. They also enter into a 2-year forward contract on euro agreeing to buy enough dollars with euro to service their loan. At the 2-year forward rate of $1.5577 this will cost 1.06 × $60m × £1.00/$2.0777 = £30,611,320.75 at the end of the second year.
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