Question

North Bank has been borrowing in the U.S. markets and lending abroad, thereby incurring foreign exchange risk. In a recent transaction, it issued a one-year $2.40 million CD at 5 percent and is planning to fund a loan in British pounds at 7 percent for a 2 percent expected spread. The spot rate of U.S. dollars for British pounds is $1.4500/£1. a. However, new information now indicates that the British pound will appreciate such that the spot rate of U.S. dollars for British pounds is $1.4300/£1 by year-end. Calculate the loan rate to maintain the 2 percent spread? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Loan rate % b. The bank has an opportunity to hedge using one-year forward contracts at 1.4600 U.S. dollars for British pounds. Calculate the net interest margin if the bank hedges its forward foreign exchange exposure? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Net interest margin c. Calculate the loan rate to maintain the 2 percent spread if the bank intends to hedge its exposure using the forward rates? (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16)) Loan rate

Answer 1

Solution :- (A)

Amount of loan in € = $2.40 million / 1.4500 = €1.655 million = €1,655,172

Interest and principal at year-end = €1.655m x 1.07 = €1.771m * 1.4300 = $2,532,579

Interest and principal of CDs = $2.40m * 1.05 = $2,520,000

Net interest income = $2,532,579 – $2,520,000 = $12,579  

Net interest margin = $12,579 / 2,400,000 = 0.00524 or 0.524 percent.

In order to maintain a 2 percent spread, Net Income = 2% * 2,400,000 = $48,000

now Amount received = $2,400,000 + $48,000 = $2,448,000

Now Amount Received in Pound = $2,448,000 / $1.43 = €1711888

Now let Rate be X

€1711888 = €1655172 * ( 1 + x )¹

X = 3.44%

(b)

If we hedge then the net interest income = €1655172 * 1.07 = €1771034

Now Convert into dollars = €1771034 * $1.46 = $2585710

now net Income = $2585710 - $2448000 = $137710

Percentage = $137710 / $2400000 = 5.74%

(c)

to maintain 2% spread

€1655172*(1+x)*1.46 = $2448000

(1+x) = 1.013

x = 1.3%