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 $2.50 million CD at 4 percent and is planning to fund a loan in British pounds at 7 percent for a 3 percent expected spread. The spot rate of U.S. dollars for British pounds is $1.440/£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 $1.43/£1 by year-end. Calculate the loan rate to maintain the 3 percent spread. b. The bank has an opportunity to hedge using one-year forward contracts at 1.46 US dollars for British pounds. Calculate the net interest margin if the bank hedges its forward foreign exchange exposure c. Calculate the loan rate to maintain the 3 percent spread of the bank intends to hedge its exposure using the forward rates. (For all requirements, do not round Intermediate calculations. Round your answers to 2 decimal places. (e.g. 32.16)) Answer is complete but not entirely correct. Loan rate Net interest margin Loan rate 7.75 3.10 5.50 % % %

Answer 1

A) Since the Currency rates are changing after 1 year the same amount of British pound will return less US Dollar .So loan  rates need to increase to compensate for this possible loss. In this case for 3% return North Bank should get back total

USD2.5M*1.07 = USD2,675,000 or British Pound (2675000/1.43)= BP 1,870,629.37 at the end of the year

Initial Principal British Pound was USD 2500000/1.44 = BP 1,736,111.11

So interest earned on the Pound is 1870629.30/1736111.11 = 7.75%

ANSWER 7.75%

B) Here initial Pound amount is USD 2500000/1.44= BP 1736111.11

At 7% interest final BP amount is 1736111.11*1.07 =1857638.89 at the end of the year . This is equivalent to 1857638.89*1.46= USD 2712152.78 at the end of the year . So total interest earned during the year in USD is 2712152.78/2500000=8.5% . Since Dollar was borrowed at 4% net interest margin is 8.5-4 =4.5% . ANSWER 4.5%

C) for 3 percent spread over dollar bank has to earn 4+3= 7% which is 1.07*USD 2,500,000 = USD 2675000 by the end of the year

This is equivalent in Pounds to be 2675000/1.46( hedge rate) = British Pound 1,832191.78 at end of year   

Initial Loan amount was USD 2.5Mi/1.44 = BP 1736111.11 at the beginning of the year

So Pound Loan interest is 1832191.78/1736111.11 =5.5%  So Answer is 5.5%