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 $2.25 million CD at 4 percent and is planning to fund a loan in British pounds at 7 percent. The spot rate of U.S. dollars for British pounds is $1.4530/£1.

a.

The bank analysts now indicate that the British pound will appreciate such that the spot rate of U.S. dollars for British pounds will be $1.4300/£1 by year-end. Calculate the new loan rate required to earn a 3 percent $net return (net dollars made at end of year are 3% more than the initial borrow amount of $2.25 million) if the information about the future spot rate is accurate. (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 per British pound. Calculate the $net return if the bank hedges by selling its expected pound loan proceeds through the forward contract. Use the original loan rate given in the question, not the rate solved for in part a. (Do not round intermediate calculations. Round your answer to 2 decimal places. (e.g., 32.16))

$Net return

%

  

Answer 1

Solution A
Dollar CD amount	2,250,000
Interest charged	4%
Spread required	3%
Required amount	2250000*(1+7%)
Required amount	2,407,500.00
Closing exchange rate	1.43	per pound
Loan maturity amount	=2407500/1.43
	1,683,566.43
Loan amount given in Pound	2250000/1.4530
Loan amount given in Pound	1,548,520.30
Interest rate required	(1683566.43/1548520.30)-1
Interest rate required	0.08720979
Interest rate required	8.72%
Solution B
Loan given in pounds	1,548,520.30
Interest rate charged	7%
maturity amount	1656916.724
Forex rate locked in forward contract	1.46
Net US proceeds	=1656916.72*1.46
Net US proceeds	2,419,098.41
CD Amount payable	2250000*(1+4%)
CD Amount payable	2,340,000.00
Net amount received	=2419098.4112-2340000
Net amount received	79,098.41