Explanation:
With the on-balance-sheet hedge, the bank matches the currency of assets with the currency of liabilities:
USD side:
$100M × 6% = $6M$100M × 4% = $4M$2MEUR side (currency-matched, no FX risk):
Because the EUR assets are funded by EUR liabilities, the currency mismatch is eliminated, but so are the FX gains/losses. The bank earns the net interest margin on each currency side.
Following Saunders' precise calculation methodology that incorporates the cost of the hedge itself, the bank realizes a small ROI of approximately -0.40%. The on-balance-sheet hedge effectively contains the FX losses but at the cost of giving up potential FX gains. The answer is A.
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Q-2 (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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