Question

Assume the following information regarding U.S. and European annualized interest rates:

Currency                                           Lending Rate           Borrowing Rate

U.S. Dollar ($)                                           0.0674                          .072

Euro (€)                                                     .068                         0.0728

Sterling Bank can borrow either $20,600,000 million or €20,600,000 million. The current spot rate of the euro is $1.13. Furthermore, Sterling Bank expects the spot rate of the euro to be $1.10 in 90 days. What is Sterling Bank’s dollar profit from speculating if the spot rate of the euro is indeed $1.10 in 90 days?

Answer 1

20,600,000 Euros are borrowed now. The amount of Euros to pay back after 90 days = $20,600,000 * (1 + (0.0728 * 90 / 360)) = 20,974,920 Euros

The 20,600,000 Euros are converted into $ at spot rate. $ received = $20,600,000 * 1.13 = $23,278,000

$23,278,000 are invested at the lending rate of 0.0674. Euros received after 90 days = $23,278,000 * (1 + (0.0674 * 90 / 360)) = $23,670,234

$23,670,234 are converted back into Euros at the expected spot rate. Euros received = $23,670,234 / 1.10 = 21,518,395 Euros

Euro profit = final Euros received - Euros repaid on original borrowing = 21,518,395 - 20,974,920 = 543,475 Euros

Dollar profit = euro profit * expected spot rate = 543,475 * 1.13 = $614,127