Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, the FI invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. LIBOR at the end of six months is 5.5 percent. Assume both interest and principal will be reinvested in six months. Assume the spot exchange rate is €1.75/$. What should be the one-year forward rate in order for the bank to earn a spread of 1 percent?
A)€1.7344/$.
B)€1.7418/$.
C)€1.7478/$.
D)€1.7750/$.
E)€1.7842/$.

Question

Quizplus · Accepted Answer

To earn a spread of 1%, the bank needs to calculate the forward rate that equates the return from the variable rate investment to the fixed rate investment plus the desired spread. The effective annual rate from the variable rate investment is calculated using the LIBOR rates and the additional 1.5%. The forward rate is then determined using the interest rate parity condition, considering the spot rate and the effective annual rates.

Assume That Instead of Investing in Euro Bonds at a Fixed