The Bank made a 750000 loan in E The terms of the loan requi

The Bank made a $750,000 loan (in E). The terms of the loan require annual interest paymentsat 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 E0.833. The bank funded the loan with $750,000 certificate of deposits with a 1-year term and rate of 1.75%. a. What is the Direct Quote? (2 points) b. Is the transaction short-funded or long-funded? Explain. (2 points) 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) c.

Solution

a). A direct quote is simply a currency pair in which the domestic currency is the quoted currency. The bank domestic currency in the problem is USD.

b). The transaction is a short funded. The loan is funded by issuing the deposit. The loan period is for 2 years and the certificate of deposit time period is 1 year. After one year the bank to refund again by extended the certificate of deposit to another year or if the certificate of deposit is terminated bank has to look for other sources of refunding.

c). First year:

Interest Expense = 750,000 * 1.75% = 13,125 - to pay interest for CD.

Interest Income = 750,000 * .833 = 624,750 GBP * .0250 = 15,618 / .833 = 18750$ (converting pounds back to dollar)

Second year:

Interest Income = 750,000 * .833 = 624,750 GBP * .0250 = 15,618 * 1.33 = 20771.94$ (converting pounds back to dollar)

Net interest income = Interest income - Interest expenses

=( First year loan Interest + second year loan Interest ) - ( First year CD interest payment)

= (18750 + 20771.94) - (13,125)

= 39521.94 - 13125

Net interest income = 26396.94$

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C ?   =   ( A r - L r )   ×   ? i

where:

C_? = changes in profitability

A_r = risk-sensitive assets

L_r = risk-sensitive liabilities

?i = change in interest rates

c) . Interest rates raised by .5%

(100 - 100) * .05 = 0. hence the bank spread remains the same.

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d) . Interest rates raised by .25%

(100 - 100) * .0025 = 0. hence the bank spread remains the same.