Question

Bank USA recently purchased $10 million worth of euro-denominated one-year CDs that pay 10 percent interest annually. The current spot rate of U.S dollars for euros is $1.104/ €1

a.Is Bank USA exposed to an appreciation or depreciation of the dollar relative to the the euro ?

b.What will be the return on the one-year CD if the dollar appreciates relative to the euro such that the spot rate of U.S dollars for euros at the end of the year is $1.004/1€ ? (Round your answer to 3 decimal places).

c.What will be the return on the one-year CD if the dollar depreciates relative to the euro such that the spot rate of U.S dollars for euros at the end of the year is $1.204/€1 ? (Round your answer to 3 decimal places)

a. Exposure ________

b.Return if dollar appreciates ______ %

c.Return if dollar depreciates ________ %

Answer 1

(a)

Yes, Bank USA is exposed to an appreciation or depreciation of the dollar relative to the euro. As Bank USA purchased euro-denominated CDs. So on maturity, the Bank USA will receive Euro and need to convert them into USD using the conversion rate. Hence, if the dollar appreciate against the euro, Bank USA will receive less dollar back and if dollar is depreciated against the euro, then Bank USA will receive more dollar back.

(b)

Bank USA purchased CDs worth $10 million

Equivalent amount in Euro = € (10 million / 1.104)             (As current spot rate of U.S dollars for euros is $1.104/ €1)

                                                      = € 9,057,971.014

So Bank USA purchased CDs worth € 9,057,971.014

Now it gets 10 percent interest annually

So after 1 year,

Bank USA will get = € 9,057,971.014 * (1 + 0.1)       (Amount = Principal * (1 + Rate))

                              = € 9,963,768.11594

Bank USA will now have to convert this Euros into USD using appreciated conversion rate of $1.004/1€

Equivalent amount in USD = $ 9,963,768.11594 * 1.004

                                        = $ 10,003,623.188

Annual return    = Change in Amount / Original Amount

= ($10,003,623.188 – $10,000,000)/$10,000,000

= 0.00036231

= 0.036%

(c)

Bank USA purchased CDs worth $10 million

Equivalent amount in Euro = € (10 million / 1.104)             (As current spot rate of U.S dollars for euros is $1.104/ €1)

                                                      = € 9,057,971.014

So Bank USA purchased CDs worth € 9,057,971.014

Now it gets 10 percent interest annually

So after 1 year,

Bank USA will get = € 9,057,971.014 * (1 + 0.1)       (Amount = Principal * (1 + Rate))

                              = € 9,963,768.11594

Bank USA will now have to convert this Euros into USD using depreciated conversion rate of $ 1.204/1€

Equivalent amount in USD = $ 9,963,768.11594 * 1.204

                                        = $ 11,996,376.8116

Annual return    = Change in Amount / Original Amount

= ($11,996,376.8116 – $10,000,000)/$10,000,000

= 0.19963768116

= 19.964%