14-94 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 exchange rate remains at €1.75/$ at the end of the year.What should be the one-year forward rate in order for the bank to earn a spread of 1 percent?

Question

Quizplus · Accepted Answer

First, we need to calculate the interest earned by the FI in Euros for one year.

In the first six months, the FI earns:

(5% + 1.5%) x €1,000,000 = €67,500

In the second six months, the FI earns:

(5.5% + 1.5%) x €1,067,500 = €73,828.75

Total interest earned for the year:

€67,500 + €73,828.75 = €141,328.75

Next, we need to calculate the exchange rate needed to earn a spread of 1 percent.

The amount the FI initially invested was $1,750,000 (€1,000,000 x €1.75/$).

To earn a spread of 1 percent, the FI needs to receive $1,768,750 ($1,750,000 x 1.01).

Therefore, the one-year forward rate required to achieve this is:

€141,328.75 / $1,768,750 = €0.0799/$

Multiplying by 1.75, we get:

€0.0799/$ x €1.75/$ = €0.13983

Finally, we need to calculate the one-year forward rate:

€1 / €0.13983/$ = €1.7478/$

Therefore, the answer is (C) €1.7478/$.

14-94 Assume That Instead of Investing in Euro Bonds at a Fixed