Detailed Answer
Answer (A) is correct. The effective interest rate on a loan denominated in a foreign currency is affected by changes in the exchange rates during the time the loan is outstanding. First, the amount borrowed is stated in terms of the borrowing party’s domestic currency [£10,000 × ($2.00 per £1) = $20,000]. The maturity amount of the loan in the foreign currency is then calculated (£10,000 × 1.04 = £10,400). This amount is then converted to the domestic currency at the spot rate in effect on the maturity date [£10,400 × ($2.10 per £1) = $21,840]. The difference in the amounts at the two dates is determined ($21,840 – $20,000 = $1,840), and this amount is divided by the face amount of the loan ($1,840 ÷ $20,000 = 9.2%).
