Question

A German bank issues a one-year €2,000,000 CD at 2%. It uses these funds to make a one-year US $- denominated loan to ABC Corporation at 4%. Current exchange rate is $1.15/€. The one-year forward rate (F$/€) = $1.17/€. How can the bank manager hedge the exchange rate exposure?

• The manager can buy €2,000,000 forward at the forward rate of $1.17/€.

• The bank manager can sell €2,080,000 forward at the forward rate of $1.17/€.

• The bank anager can buy $2,392,000 forward at the forward rate of $1.17/€.

• The bank manager can sell $2,392,000 forward at the exchange rate of €1.17/€.

Answer 1

The answer is to Sell $2,392,000 forward at the exchange rate $1.17/Euro

Explanation:

Note that the manager wants to hedge interest risk.

Bank uses €2,000,000 to make a one-year US $- denominated loan to ABC Corporation at 4%.

That is it lends USD 2,300,000.

$2,300,000.00

= 2000000 (€) x 1.15(USD Rate)

This is one year loan issued on 4% interest. Therefore the Bank will receive the lent money with interest after one year.

Amount in USD ($) lent	2,300,000.00
4% (Interest)	92,000.00
Total Amount Paid Back by the Loan Taker	2,392,000.00

Remeber that the €2,000,000 was also by the German Bank to issue the $2,300,000 loan(€2,000,000 = $2,300,000).

Therefore the amount paid back by the loan taker in the USD has to be converted back to EUR. Thus to hedge against exchange rate the manager can sell $2,392,000 forward at 1.17$/EUR.