North Bank has been borrowing in the U.S. markets and lending abroad, thus incurring foreign exchange risk. In a recent transaction, it issued a one-year, $2 million CD at 6 percent and funded a loan in euros at 8 percent. The spot rate for the euro was €1.45/$1 at the time of the transaction.
a. Information received immediately after the transaction closing indicated that the euro will change to €1.47/$1 by year-end. If the information is correct, what will be the realized spread on the loan inclusive of principal? What should have been the bank interest rate on the loan to maintain the 2 percent spread?
b. The bank had an opportunity to sell one-year forward euros at €1.46/$1. What would have been the spread on the loan if the bank had hedged forward its foreign exchange exposure?
c. What would have been an appropriate change in loan rates to maintain the 2 percent spread if the bank intended to hedge its exposure using the forward contracts?