Explanation:
Step-by-step calculation:
Domestic (U.S.) loan returns:
$400.00M × (1 + 0.05) = $420.00MForeign (euro-denominated) loan returns:
$200.00M / $1.15/€1 = €173.913M$1.12/€1: €187.826M × $1.12 = $210.365MTotal asset value at year-end:
$420.00M + $210.365M = $630.365MLiabilities (CDs) repayment at year-end:
$600.00M × (1 + 0.03) = $618.00MNet return (ROI):
$630.365M − $618.00M) / $600.00M$12.365M / $600.00M = 2.0609% ≈ 2.06%Key insight: By hedging FX exposure via the forward market at $1.12/€1 (a discount to the spot of $1.15/€1), the institution locks in a known dollar conversion rate for the euro loan proceeds. This eliminates FX risk and results in a net return of approximately 2.06%, which is between the cost of funds (3.0%) and the weighted yield on assets, reflecting the positive net interest margin after the off-balance-sheet hedge.
The correct answer is b) 2.06%.
Ultimate access to all questions.
Question 502.3. Suppose a U.S. financial institution has $600.0 million in assets at the start of the year, which are funded by US certificates of deposit (CDs) with a promised one-year of 3.0%. The institution invests $400.0 million domestically in U.S. loans that yield 5.0%, and the remaining $200.0 million are invested abroad in euro-denominated loans that yield 8.0%:
Assets (loans)
Invest:
$400.00 200.00` € @ 8%
(Loans made in euros)
Liabilities (CDs)
Lend:
$600.00 $ @ 3%
Rather than match foreign asset position with liabilities (i.e., on balance sheet hedging), the institution uses the forward FX market to employ an off-balance-sheet hedge. The exchange rate of dollars for euros at the beginning of the year is $1.15/€1. The current forward one-year exchange rate between dollars and euros is $1.12/€1; that is, the forward trades at a $0.03 discount to the spot FX rate. Which is nearest to return on investment (ROI or "net return," which is different than the net interest margin) over the year?
A
1.52%
B
2.06%
C
3.00%
D
4.17%
No comments yet.