To benefit from the low correlation between the Canadian dollar (C$) and the Japanese yen (¥), Martha ltd decides to borrow 50 per cent of funds needed in Canadian dollars and the remainder in yen. The domestic financing rate for a one-year loan is 7 per cent. The Canadian one-year interest rate is 6 per cent and the Japanese one-year interest rate is 10 per cent. Martha has determined the following possible percentage changes in the two individual currencies as follows: Currency
Percentage Change
Probability
Canadian dollar
2)0%
30%
Canadian dollar
4)0%
70%
Japanese yen
-3)0%
60%
Japanese yen
1)0%
40%
What is the expected effective financing rate of the portfolio Martha is contemplating (assume the two currencies move independently from one another)?
A) 9.03%
B) 7.00%
C) 10.00%
D) 7.59%
E) None of the above

Question

Quizplus · Accepted Answer

The expected effective financing rate is the weighted average of the domestic financing rate and the foreign financing rates, where the weights are the proportions of funds borrowed in each currency. In this case, Martha is borrowing 50% of funds in Canadian dollars and 50% in yen. The domestic financing rate is 7%, the Canadian one-year interest rate is 6%, and the Japanese one-year interest rate is 10%. The expected effective financing rate is therefore:(0.5 * 7%) + (0.5 * (0.6 * (1 + 0.02) + 0.7 * (1 + 0.04) + 0.1 * (1 - 0.03) + 0.4 * (1 + 0.01))) = 9.03%

To Benefit from the Low Correlation Between the Canadian Dollar