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How did they arrive at the UK rates of 8.25% – 8.5% using the interest rate parity expression given in the answer?
I do not have the Kaplan Exam Kit, only the BPP Revision Kit.
If it is a past exam question, then tell me which exam sitting and the name of the question – then I will be able to find it. Otherwise I am sorry but I cannot help you.
IThe name of the question is Somax Plc.
Extract: Somax wants to raise funds in Swiss francs for a project.
Exchange Rates
Spot. Sfr 2.3245 – 2.3300/E
6m foward Sfr 2.2955 – 2.3009/ESomax can borrow in Sfr at floating rate of between 5.75% and 6% depending on which form of borrowing is selected(is in the Euro market or the Swiss domestic market).
Sfr Libor is currently 5%.
The interest rate parity theorem may be assumed to hold.
Question:
Estimate the UK sterling cost of capital that Somax should use as the discount rate for its investment in Switzerland.
In their solution they gave the following expression based on the interest rate parity theorem and the mid rate exchange rates;
2.2982= 2.3273X(1+Swiss rate)/(1+UK rate).
They worked this out to get UK rate of 8.25% – 8.5% per annum which I don’t understand..
I think you are happy with the actual interest rate parity theorem as you have written it.
However because that is the formula for the 6 month forward rate, you need to use the 6 month interest rates of 5.75/2 = 2.875% and 6/2 = 3%.
It still does not give exactly the answer that you have given from Kaplan (maybe there is a typing mistake, or they have rounded) but it is close enough.
For a half year rate of 3%, the formula becomes:
2.2982 = (2.3273 x 1.03) / (1 + UK rate)
Therefore 1 + UK rate = (2.3273 x 1.03)/2.2982 = 1.043So the six monthly UK rate is 0.043 or 4.3%, and therefore the annual rate is 8.6%
Same approach for a half year rate of 2.875%
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