On January 1, the cost of borrowing Hong Kong dollars (HKD) for one ye

QUESTION

On January 1, the cost of borrowing Hong Kong dollars (HKD) for one year was 18 percent. During the year the U.S. inflation rate was 2 percent and the Chinese inflation rate was 9 percent. The exchange rate on January 1 was HKD7/$. On December 31, the exchange rate was HKD8/$. If you borrowed HKD100,000 on January 1, converted this to dollars and used these funds for one year, and then paid off the HKD loan on December 31, what was the real cost of borrowing HKD for one year?
1. Determine the real cost of borrowing for HKD for 1 year First, calculate the amount needed to be paid back at the end of 1 year by borrowing HKD 100,000. This is calculated by multiplying the borrowing amount by 1 plus the borrowing rate of 18%. Amount needed to pay back after 1 year=Borrowed amount x (1+Borrowed rate) =HKD 100,000 x (1+18%) =HKD=118,000 2. Convert the borrowed amount to US dollars =Amount in HKD/Spot exchange rate =HKD 100,000/HKD 7 =$14,286 3. Convert the borrowed amount in US dollars at the end of 1 year=Amount in HKD/Forward exchange rate =HKD 118,000/HKD 8 =$14,750 4. Now, calculate the nominal interest rate by aking the difference the¦

ng and begining value of in US dollars and dividing the results by the beginiing value. Nominal interest rate=(Ending amount-Beginning amount)/Beginning amount =(14,750-14,286)/14,286=3.25% 5. Calculate the Real cost of borrowing HKD for one year by subtracting the 2% inflation in US from the nominal interest rate of 3.25% Real cost=Nominal interest cost-Inflation rate =3.25%-2%=1.25% Therefore the real cost of borrowing HKD for 1 year is 1.25%

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