Question

Question: Peter wants to save $500,000 to buy a sport car. He plans to make a deposit of $8,000 each month to achieve this goal. ABC Bank offers a deposit rate of 0.5% per month while DEF Bank offers a deposit rate of 6% with quarterly compounding.

c) ABC bank has poor credit ratings and the management of the bank has recently offered higher saving interest rates to attract and retain new customers. Peter told you that he can also formulate a strategy that can achieve his target without using any of his own capital. The strategy is to borrow a 5-year loan of $400,000 from OZ bank with a fixed monthly interest rate of 0.1%, and immediately, he deposits the whole amount into ABC bank saving account to earn an interest rate spread of 0.4% (0.5% - 0.1%). Peter believed that his plan is perfect, risk free and does not need any capital funding at all. He also claimed that he will know exactly how long he has to wait by simply solving the variable “t” in the below equation 1: Equation 1: $400,000(1 + 0.4%) ? = $500,000 i) Solve the value of “t” in above equation 1. Do you agree with Peter’s strategy? Briefly explain your answer [within 50 words]. ii) Do you agree with Peter’s strategy is really so perfect and has no risk as he think? Briefly explain your answer [within 150 words].

Answer 1

1) $400,000(1+0.4%)t = $500,000

solving for t we get t = 1.245 months

No, I don't agree with Peter's strategy at all. It has 2 basic flaws:

i) The profit that he can make is just the interest and he will need to pay back $400,000 which is the principal.

ii) The correct equation should be:

$400,000(1+0.4%)^t -$400,000 = $500,000

on solving for t we get t = 203.14 months which is more than 5 years and hence it is not a good startegy.

2) No i don't think that it is perfect startegy and has no risk at all. Since ABC bank has a poor credit rating and hence the interest rate offered on deposits is significantly higher. the biggest risk is in the form of credit risk of the bank if it defaults on its deposits.