Question

The Green Bank expects the exchange rate for the euro to depreciate from the spot rate of $0.15 to $0.14 in 10 days. Green Bank is able to borrow $10 million or 70 million euros. The short term interest rates (annualized) in the interbank market are as follows: CURRENCY LENDING RATE BORROWING RATE U.S Dollars 8% 8.3% Euro 8.5% 8.7% (a)How will the Green Bank attempt to capitalize on this expected change in exchange rate to make a speculative profit? Estimate the profit (if any) that could be generated from this strategy. (b)Assuming the expectation is that the euro will appreciate from $0.15 to $0.17 in 30 days. What change in strategy would be required for the Bank to earn a speculative profit? Determine the profit that could be earned.

Answer 1

a. Green bank should borrow now 70 million euros @ 8.7% and convert to dollars at spot rate of $ 0.15, which will give $ 10.5 million and reconvert after 10 days, $ 10.5 million @ exchange rate of $ 0.14, which will give 75 million euros

Interest for 10 days = 70 × 8.7% × 10 ÷ 365

= 0.17 million euros

Amount to be repaid after 10 days is 70 + 0.17 = 70.17 million euros

Profit = 75 - 70.17 = 4.83 million euros

b. Green bank should borrow now $ 10 mn and convert at spot rate of $ 0.15 and get 66.67 mn euros and reconvert after 30 days at exchange rate of $ 0.17 and get back $ 11.33 mn

Interest to be paid for 30 days is

10 × 8.3% × 30 ÷ 365

= $ 0.068 mn

Amount to be repaid is 10 + 0.068 = $ 10.068 mn

Profit = 11.33 - 10.068 = $ 1.262 mn