A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom.
-If the spot foreign exchange rate remains constant at $1.60 to ≤1 throughout the year, the return from the U.K. investment will be
A)15%.
B)12%.
C)16%.
D)13%.
E)7%.

Question

A U.S. FI is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50 percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets (one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in dollars at the end of the year, and that one-year, credit risk-free loans in the United States are yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United Kingdom. 
-If the spot foreign exchange rate remains constant at $1.60 to ≤1 throughout the year, the return from the U.K. investment will be
A)15%. 
B)12%. 
C)16%. 
D)13%. 
E)7%.

Quizplus · Accepted Answer

The U.S. FI is raising all its liabilities in U.S. dollars and investing 50% in U.S. dollar assets and 50% in pound sterling assets. The U.S. FI can invest the dollars raised in the U.S. at a rate of 10%. At an exchange rate of $1.60/$1, the U.S. FI can convert half of the amount raised to pounds at a rate of £12.50/$1 ($20,000,000/£1,600,000) and invest it in the U.K at a rate of 16%.

The total return from the U.K. investment will be:

Return from U.K investment = U.K interest rate - currency depreciation

Currency depreciation = 0 since the spot exchange rate remains constant.

Return from U.K investment = 16% - 0 = 16%

Therefore, the best choice is C.

A US FI Is Raising All of Its $20 Million Liabilities