Question

)A New York City Bank expects the exchange rate for the euro to appreciate from the spot rate of $0.60 to $0.65 in 90 days. The Bank is able to borrow $15 million or 25 million euros. The short term interest rates (annualized) in the interbank market are as follows:
CURRENCY                            LENDING RATE                      BORROWING RATE
U.S Dollars                                    6.72%                     7.2%
Euro                                              6.48%                  6.96%
(a)How will this bank attempt to capitalize on this expected change in exchange rate to make a speculative profit? Estimate the profit (if any) that could be generated from this strategy.
(b)Assuming the expectation is that the euro will depreciate from $0.60 to $0.55 in 90 days. What change in strategy would be required for the Bank to earn a speculative profit? Determine the profit that could be earned.

Answer 1

As Exchange rate for the euro i.e Euro to $ is to appreciate from the spot rate of $ 0.60 to $ 0.65 in 90 days , which means for 1 Euro bank will expected to get $ 0.65 instead of $ 0.60 in 90 days.

Hence, it is recommended to invest in Euro than $.

(a) As Euro will appreciated , Hence it is recommended to invest in Euro than $. Bank will capitalize expected change in exchange rate to make speculative profit as follows:

Steps :

1. Borrow $ 15,000,000 to invest in Euro at 7.2% per year for 90 days

2. Convert $ 15,000,000 in Euro at spot rate at $ 0.60 per Euro.

= $ 1,5000,000 x (1 / $ 0.60 ) = Euro 25,000,000

3. Lend Euro 25,000,000 at 6.48% per year for 90 days

4. Amount get back after 90 days with interest in Euros:

Particulars	Euro
Lending Amount	25,000,000
Add: Interest at 6.48% for 90 days = 25000,000 Euro x 6.48 % x ( 90 days / 365 days)	399,452.05
Total Amount with interest	25,399,452.05

5. Convert it into $ at 90 days Spot rate for Euro at $ 0.65 per Euro

= 25,399,452.05 x 0.65 = $ 16509643.84 /-

6. Pay borrowings with interest :

Amount paid against borrowing in $ with interest for 90 days

Particulars	$
Borrowing	15,000,000
Add: Interest at 7.2% for 90 days = $ 15,000,000 x 7.2% x ( 90 days / 365 days )	266,301.37
Amount paid against borrowing in $ with interest	15,266,301.37

7. Speculative Profit :

= Amount converted in $ after 90 days - Amount of borrowing with interest for 90 days

= $ 16,509,643.84 - 15,266,301.37 = $ 1,243,342.47 /-

or 1912834.57 Euro ( $ 1243342.47 x (1 / $ 0.65) per Euro )

(b) Assuming the expectation is that the euro will depreciate from $0.60 to $0.55 in 90 days.

In such case the change in strategy & speculative profit would be as follows :

As Exchange rate for the euro i.e Euro to $ is to depreciate from the spot rate of $ 0.60 to $ 0.55 in 90 days , which means for 1 Euro bank will expected to get $ 0.55 instead of $ 0.60 in 90 days.

Hence, it is recommended to invest in $ than Euro

Steps :

1. Borrow Euro 25,000,000 to invest in Euro at 6.96% per year for 90 days

2. Convert Euro 25,000,000 in $ at spot rate at $ 0.60 per Euro.

= Euro 25,000,000 x $ 0.60 ) = $  15,000,000

3. Lend $ 15,000,000 at 6.72% per year for 90 days

4. Amount get back after 90 days with interest in $:

Particulars	$
Lending Amount	15,000,000
Add: Interest at 6.72% for 90 days = 15,000,000 Euro x 6.72 % x ( 90 days / 365 days)	248,547.95
Total Amount with interest	15,248,547.95

5. Convert it into Euro at 90 days Spot rate for $ at $ 0.55 per Euro

= 15,248,547.95 x (1/ 0.55) = Euro 27,724,632.63 /-

6. Pay borrowings with interest :

Amount paid against borrowing in Euro with interest for 90 days

Particulars	Euro
Borrowing	25,000,000
Add: Interest at 6.96 % for 90 days = Euro 25,000,000 x 6.96% x ( 90 days / 365 days )	429,041.10
Amount paid against borrowing in Euro with interest	25,429,041.10

7. Speculative Profit :

= Amount converted in Euros after 90 days - Amount of borrowing with interest for 90 days

= Euro 27,724,632.63 -  25,429,041.10 = 2,295,591.53

or $ 1,262,575.34 ( 2,295,591.53 Euro x $ 0.55 per Euro )