Your U.S.bank issues a one-year U.S.CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar)investment in two-year,fixed rate Canadian bonds selling at par and paying 7 percent annually.You expect to liquidate your position in one year.Currently,spot exchange rates are U.S.$0.78493 per Canadian dollar.

If in one year there is no change to either interest rates or exchange rates,what is the end-of-year profit or loss for the bank? (Hint: Annual interest is paid on both the Canadian bonds and the CD on the date of liquidation in exactly one year. )

Question

Your U.S.bank issues a one-year U.S.CD at 5 percent annual interest to finance a C $1.274 million (Canadian dollar)investment in two-year,fixed rate Canadian bonds selling at par and paying 7 percent annually.You expect to liquidate your position in one year.Currently,spot exchange rates are U.S.$0.78493 per Canadian dollar.

If in one year there is no change to either interest rates or exchange rates,what is the end-of-year profit or loss for the bank? (Hint: Annual interest is paid on both the Canadian bonds and the CD on the date of liquidation in exactly one year. )

Quizplus · Accepted Answer

Profit (loss) = ($ income earned on loan) - ($ cost of funds)
 U.S. Dollar amount of CD issued to fund Canadian loan = [C $1,274,000 * (U.S. $0.78493/C $1)] = U.S. $1,000,000
 U.S. Dollar amount of loan and loan revenue = [(C $1,274,000 * 1.07) * (U.S. $0.78493/C $1)] = C $1,363,180 * U.S. $0.78493 = U.S. $1,070,000
 Profit (loss) = (U.S. $1,070,000) - (U.S. $1,000,000 * 1.05) = U.S. $20,000.

Your USBank Issues a One-Year U