Yen Bank wishes to invest in Yen loans at a rate of 10 percent. The bank will fund the loans in the domestic CD market at a rate of 6.3 percent. This on-balance-sheet FX risk will be hedged in the spot market at a forward rate of $0.62/×. The spot rate on yen is $0.60/×.
-What must be the forward exchange rate to eliminate the preference for the yen loans?

Question

Quizplus · Accepted Answer

To eliminate the preference for the yen loans, the effective interest rate of funding the loans in yen and then hedging the FX risk with forward contract should be equal to the domestic CD market rate of 6.3 percent.
Let X be the forward rate that will eliminate the preference for yen loans.
Effective interest rate of yen loans = 10% - (X-0.62)/(0.62) = 10% - 1.6129X + 1.0161
Effective interest rate of hedging with forward contract = (X-0.6)/(0.6) = 1.6667X - 1
When the effective interest rate of yen loans is equal to the domestic CD market rate, we have:
10% - 1.6129X + 1.0161 = 6.3%
Solving for X, we get:
X = 0.5798/×
Therefore, the forward exchange rate that will eliminate the preference for yen loans is $0.5798/×.

Yen Bank Wishes to Invest in Yen Loans at a Rate