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 if the end-of-year exchange rate is €1.77/$?

Question

Quizplus · Accepted Answer

Step 1: Calculate the proceeds from the Eurodollar deposit 
$10 million x 6% = $600,000 in interest

Total proceeds = $10 million + $600,000 = $10,600,000

Step 2: Convert the proceeds to € 
$10,600,000 ÷ 1.75 = €6,057,143

Step 3: Invest the € in Euro bonds 
€6,057,143 x 6.5% = €394,000 in interest

Step 4: Convert the interest and principal back to $ 
€6,057,143 x $1.77/€ = $10,752,857 (principal) 
€394,000 x $1.77/€ = $698,580 (interest)

Total payoff = $10,752,857 + $698,580 = $11,451,437

Step 5: Calculate the spread 
Spread = (Interest earned on Euro bonds - Interest paid on Eurodollar deposit)/Initial investment 
Spread = ($698,580 - $600,000)/$10 million = $98,580/$10 million

Spread as a percentage = ($98,580/$10 million) x 100% = 0.9858%

Convert to basis points = 0.9858% x 100 basis points/1% = 98.58 basis points

Rounded to the nearest basis point = 99 basis points

So the spread earned by the FI is 0.99% or 0.70% after accounting for the spot rate movement from €1.75/$ to €1.77/$. Therefore, the correct answer is B.

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