A bank purchases a six-month $4 million Eurodollar deposit at an interest rate of 7.6 percent...

A bank purchases a six-month $4 million Eurodollar deposit at an interest rate of 7.6 percent per year. It invests the funds in a six-month Swedish krona bond paying 8.6 percent per year. The current spot rate of U.S. dollars for Swedish krona is $0.1800/SKr.

a. The six-month forward rate on the Swedish krona is being quoted at $0.1810/SKr. What is the net spread earned for six months on this investment if the bank covers its foreign exchange exposure using the forward market?
b. At what forward rate will the spread be only 1 percent per year?

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Answer:

a. The six-month forward rate on the Swedish krone is being quoted at $0.1810/SK1. What is the net spread earned on this investment if the bank covers its foreign exchange exposure using the forward market?

Interest plus principal expense on six-month CD = $4m x (1 + 0.076/2) = $4,152,000

Principal of Swedish bond = $4,000,000/0.18 = SK22,222,222.22

Interest and principle = SK22,222,222.22 x (1 + 0.086/2) = SK 23,177,777.78

Interest and principle in dollars if hedged: SK 23,177,777.78 x 0.1810 = $4,195,177.78

Spread = $4,195,177.78- 4,152,000 = $43,177.78/4 million = 0.010764 for 6 months, or 2.1589 percent annually

b.

In this case, net interest income should be = (0.01/2) x 4,000,000 = $20000

Therefore, interest income should be = $4195177.78 - $20000 = $4,175,177.78

Forward rate = $4,175,177.78/SK23,177,777.78 = $0.1801371/SK1 (round off as required)

jeff jeffy answered 1 year ago

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