A U.S. bank issues a 1-year, $1 million U.S. CD at 5 percent annual interest to finance a C $1.274 million investment in 2-year fixed-rate Canadian bonds selling at par and paying 7 percent annually. You expect to liquidate your position in 1 year upon maturity of the CD. Spot exchange rates are US $0.78493 per Canadian dollar.
-What is the end-of-year profit or loss on the bank's cash position if in one year the exchange rate falls to US $0.765/C $1? Assume there is no change in interest rates. (Choose the closest answer)

Question

Quizplus · Accepted Answer

Initially, the bank invests $1 million at 5% interest, earning $50,000 in interest over the year. The Canadian bonds pay 7% annually, earning C $89,180 in interest over the two-year investment period.

After one year, the CD matures and the bank receives the initial investment plus the earned interest, totaling $1,050,000. At the exchange rate of US $0.78493/C $1, this is equivalent to C $1,338,532.

If the exchange rate falls to US $0.765/C $1, the value of the investment in Canadian dollars is now C $1,297,293. The bank's profit or loss in Canadian dollars is therefore C $297,293.

Converting this back to US dollars at the new exchange rate, the bank's profit or loss is approximately US $7,082 [(C $297,293) x (US $0.765/C $1) - $1,050,000]. Therefore, the correct answer is C) Loss of US $7,000.

A US Bank Issues a 1-Year, $1 Million U