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Answer: 13.50%
**Correct answer: D. 13.50%** Using the hedged cash flows: - Six-month Eurodollar deposit repayment: $1{,}000{,}000 \times \left(1 + \frac{0.025}{2}\right) = $1,012,500$ - Swedish bond principal in SEK: $1{,}000{,}000 / 0.1140 = 8,771,929.82$ SEK - Swedish bond value at maturity in SEK: $8,771,929.82 \times \left(1 + \frac{0.035}{2}\right) = 8,925,438.60$ SEK - Converted back to USD using the forward rate: $8,925,438.60 \times 0.1210 = $1,079,978.07$ Net spread for six months: - $1,079,978.07 - 1,012,500.00 = 67,478.07$ in favor of the investment - As a fraction of $1,000,000: 0.06748$ for six months - Annualized with semiannual compounding: approximately **13.50%**
Author: Manit Arora
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Question 1.1. A bank purchases a six-month, $1.0 million Eurodollar deposit at an interest rate of 2.5% per annum with semiannual compounding. It invests the funds in a six-month Swedish krone AA-rated foreign bond paying 3.5% per annum. The current SEKUSD spot rate is $0.1140 per 1.0 krone (kr, https://en.wikipedia.org/wiki/Swedish_krona). The six-month forward rate on the Swedish krone is being quoted at SEKUSD $0.1210. If the bank covers its foreign exchange exposure using the FX forward market, which is nearest to the net spread earned on this investment per annum with semiannual compounding? (Note: variation on Saunders’ Question #22)
A
2.38%
B
4.75%
C
7.93%
D
13.50%
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