Yen Bank wishes to invest in Yen loans at a rate of 10 percent.The bank will fund the loans in the domestic CD market at a rate of 6.3 percent.This on-balance-sheet FX risk will be hedged in the spot market at a forward rate of $0.62/×.The spot rate on yen is $0.60/×. What must be the spot exchange rate to eliminate the preference for the yen loans if the forward rate remains $0.62/×?

Question

Quizplus · Accepted Answer

To eliminate the preference for yen loans, the return on yen loans must equal the return on domestic CD investments when adjusted for the exchange rate. The return on yen loans is 10%, and the cost of funding these loans is 6.3%, resulting in a net return of 3.7%. To find the required spot exchange rate, we use the formula for calculating the return on a hedged foreign investment: $$Return = \frac{(1 + i_{foreign}) \times \frac{Forward Rate}{Spot Rate}}{1 + i_{domestic}} - 1$$ where $i_{foreign} = 10\%$, $i_{domestic} = 6.3\%$, and the Forward Rate is $0.62/¥. We set the return equal to 3.7% and solve for the Spot Rate. Rearranging the formula and substituting the given values, we find that the Spot Rate that eliminates the preference is $0.6416/¥, which matches option A.

Yen Bank Wishes to Invest in Yen Loans at a Rate