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 $1.75 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

Let us try to solve it in the easy way possible:-

Amount of loan incurred €=$1. 75X 1.45=€2.53 Million

Interest and principal at year-end=€2.53X1.06=€2.68/1.43

=€1,874,125.87

Interest and principal ofCD's=

$1.75 million X1. 04(4%)=$1,80,000

Net interest income=$ 1,874,125.87-1,80,000

=$74,125.87/2=0.0037

In order to maintain a 2% spread , the principal and interest earned at $1.43/€1 should be

€2.53(1+x)/1.43=1.82( because 1.82-1.80=0.02)

Therefore, (1+x)=(1.82 X1. 43)/$2.53= 1.02869 and x= 2.89% or 0.0286

b) Net interest income of the bank if hedged=€2.53X 1.06=2.68/1.46

=1.8368 million -1.80 million

=0.03684931 or $36,849.31

Net interest margin=0.0368/2=0.0184 or 18.4%

c)Now in this situation of the bank hedge its exposure using the forward rate then it will be calculated as:-

Firstly to maintain the balance of 2% spread,

Again,

€2.53(1+x)/1.46=1. 82

The bank should increase the rates and hedge with the sale forward €s to maintainthe 2%,spread rate along with 6% interest rate.