Austin Co. needs to borrow $10 million for the next year to support its U.S. operations. It can borrow U.S. dollars at 7 percent or Japanese yen at 1 percent. It has no other cash flows in Japanese yen. Assume that interest rate parity holds, so the 1-year forward rate of the yen exhibits a premium in this case. Austin expects that the spot rate of the yen will appreciate but not as much as suggested by the 1-year forward rate of the yen.
a. Should Austin consider financing with yen and simultaneously purchasing yen 1 year forward to cover its position? Explain.
b. If Austin finances with yen without covering this position, is the effective financing rate expected to be above, below, or equal to the Japanese interest rate of 1 percent? Is the effective financing rate expected to be above, below, or equal to the U.S. interest rate of 7 percent?
c. Explain the implications if Austin finances with yen without covering its position and the future spot rate of the yen in 1 year turns out to be higher than today's 1-year forward rate on the yen.