An FI has purchased (borrowed)a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent.It has invested these proceeds in one-year Euro (€)bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$.Both interest and principal are paid at the end of the year.

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent,the FI invests them in variable rates of LIBOR + 1.5 percent,reset every six months.The current LIBOR rate is 5 percent.Assume both interest and principal will be reinvested in six months.Assume the exchange rate remains at €1.75/$ at the end of the year.What should be the LIBOR rates in six months in order for the bank to earn a 1 percent spread?

Question

An FI has purchased (borrowed)a one-year $10 million Eurodollar deposit at an annual interest rate of 6 percent.It has invested these proceeds in one-year Euro (€)bonds at an annual rate of 6.5 percent after converting them at the current spot rate of €1.75/$.Both interest and principal are paid at the end of the year.

Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent,the FI invests them in variable rates of LIBOR + 1.5 percent,reset every six months.The current LIBOR rate is 5 percent.Assume both interest and principal will be reinvested in six months.Assume the exchange rate remains at €1.75/$ at the end of the year.What should be the LIBOR rates in six months in order for the bank to earn a 1 percent spread?

Quizplus · Accepted Answer

To earn a 1% spread, the FI needs to earn 7% (6% cost + 1% spread) on its investment. The first 6 months earn 6.5% (5% LIBOR + 1.5%), so the second 6 months must also earn 7.5% (5.76% LIBOR + 1.5%) to average 7% over the year.

An FI Has Purchased (Borrowed)a One-Year $10 Million Eurodollar Deposit