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.
A)0.50 percent.
B)0.68 percent.
C)0.86 percent.
D)0.90 percent.
E)0.95 percent.

Question

Quizplus · Accepted Answer

The bank earns LIBOR + 1.5% for the first six months (5% + 1.5% = 6.5%) and LIBOR + 1.5% for the next six months (5.5% + 1.5% = 7%). The average annual rate is (6.5% + 7%)/2 = 6.75%. The spread over the fixed rate of 6.5% is 6.75% - 6.5% = 0.25%. However, the question asks for the annual spread earned, which is the difference between the variable rate and the fixed rate over the entire year, calculated as (1.0675/1.065 - 1) = 0.86%.

Assume That Instead of Investing in Euro Bonds at a Fixed