The upward movement of the exchange rate can increase the total cost of a loan by making the principal repayment require more money than the original amount of the loan. True or False
The correct answer and explanation is:
Answer: True
Explanation:
When a loan is denominated in a foreign currency, changes in the exchange rate can significantly affect the total cost of repaying that loan. Specifically, if the exchange rate moves upward—meaning the foreign currency strengthens relative to the borrower’s home currency—then the borrower will need to spend more of their home currency to buy the same amount of foreign currency to repay the loan principal and interest.
Here’s how it works:
- Suppose a borrower takes out a loan in U.S. dollars but operates in another currency, say Kenyan shillings (KES).
- If the exchange rate rises from 100 KES/USD to 110 KES/USD, the U.S. dollar has appreciated against the Kenyan shilling.
- This means that to repay the same dollar amount of the loan principal, the borrower now needs more Kenyan shillings because each dollar costs more in shillings.
- For example, if the loan principal is $10,000, initially the borrower needed 1,000,000 KES (10,000 × 100) to repay it.
- After the exchange rate increase, the borrower will need 1,100,000 KES (10,000 × 110) to repay the same $10,000 loan.
- The increased cost arises purely from the exchange rate change, not from any increase in the loan amount or interest rate.
This exchange rate risk can significantly increase the total cost of borrowing when the loan is in foreign currency. Borrowers exposed to such risk often try to hedge against exchange rate fluctuations or prefer loans in their local currency to avoid unexpected cost increases.
In summary, an upward movement in the exchange rate (foreign currency appreciating relative to the borrower’s currency) increases the cost of repaying a foreign currency loan in the borrower’s domestic currency, making the statement true.