Question

Inno Bank has a new product in currency deposits. Below is how it’s main terms are presented to its customers: Customer makes a Euro Dollar (€) deposit with the bank. At the same time, he is required to select another currency US Dollar, say ($) to be linked to the €. The bank will then work out the conversion rate between these two currencies, (assume it is € 1 = $1.1965), and this is to be applied as below when the € deposit matures in 1 month (say). Customer is then told that the € currency deposit will yield 12.6% p.a. (which is very attractive as it is about 3.2% higher than a basic € deposit). However, there is caveat: Upon the deposit’s maturity (i.e. after 1 month), the bank will return the matured deposit (principal plus interest) in the weaker currency denomination (relative to € 1 = $1.1965) to be converted at $1.1965. You are required to answer the following questions:

(a) Analyse the structure of this innovative financial instrument, in terms of the payoff of the customer. You may simulate the various market scenarios upon the deposit’s maturity based on €100,000 deposit.

(b) What positions have the bank and the customer taken respectively in this deal? Why is the bank prepared to pay such a high interest rate to the customer?

(c) What is the bank’s outlook on the currencies in the next 1 month?

Answer 1

a) The new products of Inno bank states that the customer is allowed to deposit the amount of €100,000 @ 12.6% p.a. However, at the end of the 1 month the returns comprising of principal and interest amount which the customer would receive in the weaker currency denomination.

We will consider 2 scenarios wherein we will see the effect of different market conditions on the exchange rate of the two currency.

Scenario 1 : Euro Currency gets stronger and now the exchange rate is €1 = $1.2400

Principal of €100,000 @ interest of 12.6% p.a. time horizon of 1 month.
Interest for one month = 100,000*12.6%/12
                                          = €1050

Total Amount = 100,000+1050
                         = €101050

Converting it to USD at €1 = $1.2400


€101050 = 1.2400*101050 USD
                = $125,302

Scenario 2 : Euro Currency gets weaker and now exchange rate is ­€1 = $1.1530

Principal of €100,000 @ interest of 12.6% p.a. time horizon of 1 month.
Interest for one month = 100,000*12.6%/12
                                          = €1050

Total Amount = 100,000+1050
                         = €101050

Converting it to USD at €1 =$1.1530

€101050 = 1.1530*101050 USD
                =$116511


Scenario 3. When there is no change in exchange rate € 1 = $1.1965

For amount €101050 value in USD is = 1.1965*101050
   = $120906


b) In any scenario discussed above bank has agreed to pay the customer in a weaker currency denomination as compared to the time when the customer has depostied. Since the bank is taking Euros from the customer, the bank expects the Euros to get stronger in the next one month. With the benefit of paying in a weaker currency coupled with risk free rate of return that the bank can generate from the amount, there is willingness to pay a higher rate of return. However, the customer is anyway getting a better return as compared to other base interest rate on Euros.

c) The bank expects the Euro currency to get stronger and if it gets stronger then according to scenario 1, the bank would earn (125302-120906 = 4396) USD. In scenario 1, I have assumed that there would be a 3.6% appreciation in the Euro ,which means that the bank would gain from the euro appreciation as well as the interest from the risk-free instruments in which they have invested €100,000.