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.
-What is the spread earned by the bank at the end of the year if the exchange rate remains at €1.75/$?

Question

Quizplus · Accepted Answer

The FI's cost of funds is 6 percent on $10 million, which is $600,000. The proceeds of $10 million are converted to euros at a spot rate of €1.75/$, giving €17.5 million to invest in euro bonds. The interest earned on euro bonds at 6.5 percent is €1,137,500. The euro bonds are converted back to dollars at the same spot rate of €1.75/$, which results in $1,993,750 ($17.5 million x 1.65) at the end of the year. Hence, the spread earned by the bank is ($1,993,750 - $600,000)/$10 million, which is 0.50 percent. Therefore, the answer is A.

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