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 $1.50 million CD at 4 percent and is planning to fund a loan in British pounds at 6 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

Borrowing cost in USD = 4% & Borrowed Amount = $ 1,500,000; hence annual interest cost = $ 60,000

This borrowed amount converted into GBP shall be = 1500000 / 1.45 = GBP 1,034,482.76

At 6% in GBP (2% spread for North Bank), the GBP interest shall be = 1034482.76 * 6% = GBP 62,068.97

If the exchange rate would have remained constant, then after 1 year this GBP amount could have been converted into USD resulting in 2% net spread for the North Bank since the GBP 62,068.97 at 1.45 conversion rate would give USD 90,000 - which after paying the 4% USD interest will leave USD 30,000 (2% net spread).

(a) However, since the exchange appreciates to 1.43, we can work backwards to arrive at the GBP loan rate required to earn 2% spread. We know that to get a 2% spread, the bank should make in USD 90,000 in 1 year. When we convert this amount in GBP at 1.43 rate, we get GBP 62,937.06 - now this should be interest which should be earned to get a 2% spread. Our GBP loan amount is GBP 1,034,482.76, hence the interest rate should be (62,937.06 / 1,034,482.76) = 6.08%

(b) If the bank hedges its exposure at 1.46 exchange rate, then the 6% GBP interest of 62,068.97 shall be in USD terms equal to USD 90,620.69. This will translate into an overall return of (90,629.69/1500000) 6.04% in USD terms which will be a net spread of 2.04%

(c ) If the bank hedges at 1.46, then the GBP loan rate can be reduced marginally to maintain the 2% net spread. To get to 2% spread, the bank needs USD 90000 after 1 year in USD terms, hence in GBP terms it will be (90,000 / 1.46) = GBP 61,643.84 or 5.96% of GBP loan amount.