The Bank made a 750000 loan in The terms of the loan requir

The Bank made a $750,000 loan (in £). The terms of the loan require annual interest payments at 2.50% per year, to be fully repaid in two years (June 2020). At the time the loan was made the US dollar was worth £0.833. The bank funded the loan with $750,000 certificate of deposits with a 1-year term and rate of 1.75%.

1. What is the Direct Quote ?

2. Is the transaction short-funded or long-funded? Explain

3. When the loan matures in two years the anticipated exchange rate is £1.00 = $1.33. Calculate the Net Interest Income at the end of Year 2, assuming interest rates do not change. (6 points)

Solution

Greetings,

A) Direct quote in terms of forex market means a quite expressed as price of foreign currency in terms of home currency. For instance, in this case bank is US based so USD is home currency and GBP is foreign currency. So from bank\'s point of view, direct quote means price of GBP denoted in terms of USD. In question, they have given I direct quote ie 1 USD = 0.833 GBP. So direct quote is 1 GBP = 1/0.833 = USD 1.2

B) The transaction seems to be underfunded as bank has borrowed only for 1 year but loan maturity is of two years. Loan repayment is interest only, so principal will be recovered after 2 years only, so there is asset liability mismatch in this case.

3) Interest rate = 2.5% p.a.

It will be collected in GBP terms. Loan in GBP = 750000*0.833 = 625000

Therefore annual interest = 2.5% of 625000 = 15625

Bank will convert GBP into USD on spot rate ie 1.33 getting USD 20781.25 at year end 2.

Interest Payable on loan by bank = 750000*0.0175 = USD 13125*

Net interest Income = 20781.25 - 13125 = 7656.25

* Interest Expense has been calculated assuming that bank renews it\'s borrowing at the same rate.