Hindustan Construction Corporation arranged a two-year, $1,000,000 loan to fund

Question

Hindustan Construction Corporation arranged a two-year, $1,000,000 loan to fund a foreign project. The loan is denominated in Mexican pesos, carries a 10 percent nominal rate, and requires equal semiannual payments. The exchange rate at the time of the loan was 5.75 pesos per dollar but immediately dropped to 5.10 (pesos per dollars) before the first payment came due. The loan carried no exchange rate protection and was not hedged by Hindustan Construction Corporation in the foreign exchange market. Thus, Hindustan Construction Corporation must convert U.S. funds to Mexican pesos to make its payments. If the exchange rate remains at 5.10 pesos per dollar through the end of the loan period, what effective interest rate will Hindustan Construction Corporation end up paying on the foreign loan?

Explanation / Answer

Since there are two interest payments the effective rate is (1+.10/2)^2 -1=.1025. Since the exchange rate has dropped we have .1025 * 5.75/5.10= 0.11556.

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