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,it invests them in variable rates of LIBOR + 1.5 percent,reset every six months.The current LIBOR rate is 5 percent.What is the annual spread earned by the bank if LIBOR at the end of six months is 5.5 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.

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,it invests them in variable rates of LIBOR + 1.5 percent,reset every six months.The current LIBOR rate is 5 percent.What is the annual spread earned by the bank if LIBOR at the end of six months is 5.5 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.

Quizplus · Accepted Answer

The bank earns 6.5% on the Euro bonds initially, but with the variable rate, it earns LIBOR + 1.5%. For the first six months, it earns 6.5% (5% LIBOR + 1.5%), and for the next six months, it earns 7% (5.5% LIBOR + 1.5%). The average annual rate is 6.75%. The spread is 6.75% - 6% = 0.75%. However, due to compounding, the effective annual spread is approximately 0.86%.

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