FIM Bank is an Australian bank
FIM Bank is an Australian bank. The bank has been borrowing inthe Australian markets and lending abroad, thus incurring foreignexchange risk. In a recent transaction, it borrowed $AUD 5 millionvia a one-year security at 4.5 per cent per annum nominal andfunded a loan in Swiss Francs (CHF) at 5.0 per cent. The spot rateat the time of this transaction was 1.5152 AUD = 1 CHF (AUD/CHF= 1.5152).
(a) Information received immediately afterthe transaction closing indicated that the Swiss Franc woulddepreciate to AU$1.5102/CHF 1 by year end (i.e. 1.5102 AUD = 1CHF). If the information is correct, what will be the realisedspread on the loan? Assume adjustments in principal values areincluded in the spread. [4 marks]
(b) Suppose the bank had an opportunity tosell one-year forward Swiss Francs at AU$1.5121/CHF 1 (i.e. 1.5121AUD = 1 CHF). What would have been the spread on the loan if thebank had hedged forward its foreign exchange exposure? [3marks]
(c) Explain how forward and spot rates would bothchange in response to the spread calculated in part (b)? In youranswer, explain what the final value of the spread would be afterthe adjustment in forward and spot rates. [3marks]
Answer:
Amount in $AUD to be repaid after a year = 5*1045 = $AUD 5.225million
Amount of loan funded in CHF = 5/1.5152 =CHF 3.299894million
Amount to be realised in CHF after a year = 3.299894 *1.05 = CHF3.464899 million
a) If the Swiss Franc would depreciate to AU$1.5102/CHF 1 byyear end
Amount realised in $AUD = 3.464899 *1.5102 =$AUD 5.232676million
So, net interest realised = $AUD 0.232676 million on $AUD 5million
So, Interest rate realised = 0.232676/5 =0.046535 or 4.6535%
So, the Realised spread on the loan = 4.6535% -4.5% =0.1535%
b) If the bank had sold one-year forward Swiss Francs atAU$1.5121/CHF 1
Amount realised in $AUD = 3.464899 *1.5121 =$AUD 5.239259million
So, net interest realised = $AUD 0.239259 million on $AUD 5million
So, Interest rate realised = 0.239259/5 =0.047852 or 4.7852%
So, the Realised spread on the loan = 4.7852% -4.5% =0.2852%
c) As the spread indicates arbitrage, the forward rates and spotrates would move in a way to cancel the arbitrage. The spot rateswould go up (CHF to appreciate) and forward rates to go down (CHFto depreciate) so that the equilibrium is reached when thearbitrage is gone.
After final adjustments in the rates the spread will becomezero.
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