Answer-first summary for fast verification
Answer: ROI +2.80%
With an on-balance-sheet hedge, the EUR asset is matched by a EUR liability, so the FX movement does not create an additional open currency loss on that matched position. Compute the spread in each currency: - USD position: - Asset return = 6.0% - Funding cost = 4.0% - Spread = 2.0% on $100 million = **$2.0 million** - EUR position: - Asset return = 8.0% - Funding cost = 4.0% - Spread = 4.0% on EUR 100 million = **EUR 4.0 million** - Converted at the year-end rate of 1.26, that is about **$5.04 million** Total profit is therefore about: \[ 2.0 + 5.04 = 7.04\text{ million USD} \] Relative to the initial USD-equivalent funding base of about $240 million, the ROI is approximately: \[ \frac{7.04}{240} \approx 2.93\% \] This is closest to **2.80%**, so the correct choice is **C**.
Author: Manit Arora
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Question 193.2. Assume the same bank as in the previous question: the bank invests USD $100 million in assets to yield 6.0% and EUR 100 million to yield 8.0%. However, in this case, the bank employs an on-balance-sheet hedge. Consequently, it borrows USD $100 million, paying 4.0%, and borrows EUR 100 million, also paying 4.0%. This on-balance-sheet hedge matches the EUR 100 million invested abroad by funding with EUR 100 million. At the beginning of the year, the exchange rate is EUR/USD $1.40, which moves to EUR/USD $1.26 by the end of the year. What is the bank's ROI given it has employed this on-balance-sheet hedge?
A
ROI -0.40% (losses contained)
B
ROI about zero (per the hedge)
C
ROI +2.80%
D
ROI +4.56%
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