A NZ firm needs to borrow NZD 10 million for one year. It can borrow at a local

Question

A NZ firm needs to borrow NZD 10 million for one year. It can borrow at a local bank at 6% per
annum or it can issue bonds in Singapore denominated in Singapore dollars at 7% per annum.
The current spot rate of Singapore dollar is 0.94 S$/NZ$ and the forecasted exchange rate in one
year is 0.97 S$/NZ$.

cheaper to borrow in Singapore (3.69%) (show me step by step please?) (The other is wrong)

(2 Marks)

(a) Is it cheaper for the NZ firm to borrow in New Zealand or Singapore? Show your
calculations to justify the answer.

Explanation / Answer

Solution :
Option 1: Borrow in New Zealand

Borrowing amount : $10,000,000

Interest rate = 6% per annum

Total amount after one year = $10,000,000 * 1.06 = 10,600,000

Option 2: Issue bonds in Singapore denominated in Singapore dollars at 7% per annum

Current spot rate = 0.94 S$/NZ$

10,000,000 in New Zeland dollar will be equivalent to 10,000,000 * 0.94 S$/NZ$ = 9,400,000 Singapore dollar

interest rate = 7%

Total amount in Singapore dolllar in 1 year =  9,400,000 * 1.07 = 10,058,000

Forecasted exchange rate after one year = 0.97 S$/NZ$

Total amount in NZ dollar = amount in singapore dollar / exchange rate = 10,058,000 / 0.97 = 10,369,072

So difference of these two options = Option 1 - option 2 = 10,600,000 - 10,369,072 = 230,928

So , it is cheaper to borrow in singapore by $230,928 NZ

In percentage terms 230,928 / 10,000,000 = 2.31%

Part B )

Addition risk:

Exchange rate risk : If singapore dollar strengthens as compared to NZ dollar then the advantage of borrowing will be gone

Example: If exchange rate remains the same at 0.94 S$/NZ$ then 10,058,000 singapore dollars will be equivalent to 10,0580,000/ 0.94 = 10,700,000

So it will be costtlier to raise money in singapore dollar

How to mitigate:

in order to keep exchange rate risk contained one can hedge by future contracts or option contracts

Buy call options or go long in the future contracts

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