Explanation:
Step-by-step solution:
Borrow USD: $1,000,000 at 2.5% p.a. with semiannual compounding for 6 months
$1,000,000 × (1 + 0.025/2) = $1,000,000 × 1.0125 = $1,012,500Convert USD to SEK at spot: $1,000,000 / $0.1140 = 8,771,929.82 SEK
Invest in SEK bond at 3.5% p.a. with semiannual compounding for 6 months:
Convert SEK back to USD at forward rate of $0.1210:
$0.1210 = $1,079,977.48Net profit (6 months): $1,079,977.48 − $1,012,500 = $67,477.48
6-month return: $67,477.48 / $1,000,000 = 6.7477%
Annualize with semiannual compounding: (1.067477)² − 1 = 0.1395 ≈ 13.50%
The answer is (d) 13.50%. This illustrates a covered interest arbitrage: the bank earns the interest rate differential between the SEK and USD, plus gains from the forward premium (the SEK is selling at a forward premium since the SEK interest rate is higher than the USD rate).
Ultimate access to all questions.
P1.T3.503.1. 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 krona AA-rated bond paying 3.5% per annum. The current SEKUSD spot rate is $0.1140 per 1.0 krone (kr). The six-month forward rate on the Swedish krona 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%
No comments yet.