Como Bank is a US bank. The bank has been lending abroad and borrowing in the US markets, thus the bank is exposed to foreign exchange risk. In a recent transaction, the bank borrowed US$20 million via a one-year security at 4 per cent per annum nominal and funded a loan in Euros at 6.5 per cent. The spot rate at the time of this transaction was US$1.20= €1 (USD/Euro = 1.20). 

(a)  Immediately after the transaction closing, the bank received information indicated that the Euro would depreciate to US$1.19/ €1 by year end (i.e. US$1.19 = €1). If the information is correct, what will be the realised spread on the loan? Assume adjustments in principal values are included in the spread.

(b)   Suppose the bank had an opportunity to sell one-year forward Euros at US$1.21/€1 (i.e. US$1.21= €1). What would have been the spread on the loan if the bank had hedged forward its foreign exchange risk exposure? 

 (c)    What does interest rate parity concept imply about the spread from investing in international markets calculated in part b? 

(d) Suppose the bank decided to hedge foreign exchange risk using on-balance sheet technique. Without performing any calculations, explain the steps that would be followed to implement this technique. Explain how this technique reduces foreign exchange risk exposure. 

Answer:

(a)

Bank trust borrowed = $20 million

Funded loan percentage = 6.5%

Spot rate = 1.20USD / euro

Borrowed value in euro equipment = Bank trust borrowed / Spot rate

=$20 million / 1.20USD / euro

=20 / 1.20 million euro

Interest released @ 6.5% per annual = Borrowed value in euro equipment *(Funded loan percentage / 100)

=20 / 1.20 million euro * 6.5 / 100

=20 / 1.20 * 0.065 million Euro

This value is changed into the USD as the rate of depreciation of 1.19 USD / euro.

Interest released in USD =euro value depreciated * Interest released @6.5% per annual

=1.19 * 20 / 1.20 * 0.065 million USD

=20* 1.19 / 1.20 * 0.065 million USD ........(1)

Because the BT has to pay @ 4 percent per annual in USD

Spread realized = 20* 1.19 / 1.20 * 0.065 million USD

=-20 * 0.04 million USD........(2)

Now, apply the equation (1) and (2)

= 20* 1.19 / 1.20 * 0.065 million USD - 20 * 0.04 million USD

= 20(1.19 * 0.065/1.20) -0.04) million USD

= 20(0.0645 - 0.04) million USD

= 20 * 0.0245 million USD

= 0.49 million USD

(b)

The euro is forward 1 year @ 1.20USD/euro.

Spread realized = (20 * 1.20 / 1.20 * 0.065 - 20 * 0.04)

Because the forward rate = 1.20 USD/euro

=20 * (1.121 * 0.065 / 1.20 - 0.04) million USD

=20 (0.0651 - 0.04) million USD

=20 * 0.0251 million USD

=0.502 million USD

(c)

As evident from the (b), part spread realized differs because of the distinction in the exchange rate. In case, the rate of foreign exchange as an example in case of hedge exchange rate then the uncertainty in spread realized may be fixed similar is the case in (b) part where hedge rate of exchange fluctuation in the forward market and able to realized 0.502 million USD instead of 0.49 million USD if the rate of exchange. This would be lead to arbitrage rate realized:

Forward rate = spot rate * (1 + interest rate in c country) / (1+interest rate in b country)

(d)

The balance sheet of hedging items like foreign currency-denominated receivable and payable or holding cash is to buy a financial instrument as an example forward contract for the maturity and base value.

It also includes complying with standards of accounting which led an organization to recognize the changes in the hedged contract rate as well as in the assets underlying in the balance sheet.

As an example, the hedging instrument and hedged assets both's value have to translate into the currency of functional applying the rate of the current spot at the duration of every reporting.

Include steps:

1^st step:

Transaction value is reported in dollars at the rate of currency exchange at the transaction time.

2^nd step:

Transaction value is reported when the transaction is settled.

3^rd step:

Payment is reported at the real rate and profit/deficits are reported by accounting for the distinctions among the value of transactions and when the transaction is settled.

The profit of foreign currency is recorded here on the balance sheet's equity section.

This decreases the risk of the foreign exchange exposure like the rate of exchange is fined on the forward market at the transaction recording time and when the transactions are settled, it's realized on the section of equity-like the profit of the foreign currency.