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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 $2.00 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 $1.450/£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 $1.43/£1 by year-end. Calculate the loan rate to maintain the 2 percent spread.
b. The bank has an opportunity to hedge using one-year forward contracts at 1.46 U.S. dollars for British pounds. Calculate the net interest margin if the bank hedges its forward foreign exchange exposure.
c. Calculate the loan rate to maintain the 2 percent spread if the bank intends to hedge its exposure using the forward rates.

Answer 1

		A	Amount borrowed in US market at 4%	$2,000,000
		B	Spot Rate per British Pound	$1.45
		C=A/B	Amount of British pound received at spot rate	£ 1,379,310.34
		D=A*(1+0.04)	Future value of $2 million at 4%	$2,080,000
		E=A*(1+0.06)	Future value of $2 million at 6%	$2,120,000
		F=E-D	Spread in Dollar	$40,000
		G	Spot rate after one year per British Pound	$1.43
		H=E/G	Amount of British pound required at this rate	£ 1,482,517.48
		I=(H/C)-1	Loan Rate to   maintain 2% Spread	0.074825175
	a		Loan Rate to   maintain 2% Spread(in Percentage)	7.48%
	b		Forward rate per British Pound	$1.46
		X=C*1.06	Future Value of British Pound 1379310.34 at 6%	£ 1,462,068.97
		Y=X*1.46	Future Value in $ with forward contract	$2,134,620.69
		Z=(Y/A)-1	Interest rate received	6.73%
			Interest Margin(6.73-4)	2.73%
	c	J	Forward rate per British Pound	$1.46
		K=E/J	Amount of British Pound required at this rate	£ 1,452,054.79
		L=(K/C)-1	Loan Rate to maintain 2% Spread	0.052739726
			Loan Rate to   maintain 2% Spread(in Percentage)	5.27%