Question

A New York City Bank expects the exchange rate for the euro to appreciate from the spot rate of $0.60 to $0.65 in 90 days. The Bank is able to borrow $15 million or 25 million euros. The short term interest rates (annualized) in the interbank market are as follows:

CURRENCY                                          LENDING RATE                                           BORROWING RATE

U.S Dollars                                                 6.72%                                                            7.2%

Euro                                                           6.48%                                                            6.96%

(a)How will this bank attempt to capitalize on this expected change in exchange rate to make a speculative profit? Estimate the profit

(if any) that could be generated from this strategy.

(b)Assuming the expectation is that the euro will depreciate from $0.60 to $0.55 in 90 days. What change in strategy would be required for the Bank to attempt to earn a speculative profit? Determine the profit (if any) that could be earned.

Answer 1

Solution a:

It is assumed that there are 360 days in a year for calculation

New york city bank should borrow $15,000,000 at 7.2% and convert dollar in euro at spot rate of 1 Euro = 0.60$

Therefore bank should buy Euro = $15,000,000/$0.60 = $25,000,000

Now bank hold Euro for 90 days and sell it for 1 Euro = $0.65

Therefore Bank will get dollar after 90 days = $25,000,000*0.65 = $16,250,000

After getting dollar bank will repay the loan with interest = $15,000,000 + $15,000,000*7.2%*90/360 = $15,270,000

Total Profit to bank = $16,250,000 - $15,270,000 = $980,000

Solution b:

If expectation is that Euro will depreciation from $0.60 to $0.55, then bank should borrow 25,000,000 Euro at 6.96%, and convert them in dollar

Therefore bank should buy Dollar = $25,000,000/$0.60 = $15,000,000

Now bank hold dollar for 90 days and sell it for, $0.55 = 1 Euro

Therefore Bank will get Euro after 90 days = $15,000,000/0.55 = Euro 27,272,727.27

After getting Euro, bank will repay the loan with interest = Euro 25,000,000 + Euro 25,000,000*6.96%*90/360 =Euro 25,435,000

Total Profit to bank (In Euro) = Euro 27,272,727.27 - Euro 25,435,000 = Euro 1,837,727.27

Tota Profit to bank (In dollar) = Euro 1,837,727.27 * 0.55 = $1,010,750