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Case

Foreign Exchange Risk Exposure

Suppose that a U.S. FI has the following assets and liabilities:

The promised one-year U.S. CD rate is 4 percent, to be paid in dollars at the end of the year; the one-year, default risk–free loans in the United States are yielding 6 percent; default risk–free one-year loans are yielding 8 percent in the United Kingdom; and default risk–free one-year loans are yielding 10 percent in Turkey. The exchange rate of dollars for pounds at the beginning of the year is $1.6/£1, and the exchange rate of dollars for Turkish lira at the beginning of the year is $0.5533/TRY1.

1. Calculate the dollar proceeds from the FI’s loan portfolio at the end of the year, the return on the FI’s loan portfolio, and the net interest margin for the FI if the spot foreign exchange rate has not changed over the year.

2. Calculate the dollar proceeds from the FI’s loan portfolio at the end of the year, the return on the FI’s loan portfolio, and the net interest margin for the FI if the pound spot foreign exchange rate falls to $1.45/£1 and the lira spot foreign exchange rate falls to $0.52/TRY1 over the year.

3. Calculate the dollar proceeds from the FI’s loan portfolio at the end of the year, the return on the FI’s loan portfolio, and the net interest margin for the FI if the pound spot foreign exchange rate rises to $1.70/£1 and the lira spot foreign exchange rate rises to $0.58/TRY1 over the year.

4. Suppose that instead of funding the $300 million investment in 8 percent British loans with U.S. CDs, the FI manager funds the British loans with $300 million equivalent one-year pound CDs at a rate of 5 percent and that instead of funding the $200 million investment in 10 percent Turkish loans with U.S. CDs, the FI manager funds the Turkish loans with $200 million equivalent one-year Turkish lira CDs at a rate of 6 percent. What will the FI’s balance sheet look like after these changes have been made?

5. Using the information in part 4, calculate the return on the FI’s loan portfolio, the average cost of funds, and the net interest margin for the FI if the pound spot foreign exchange rate falls to $1.45/£1 and the lira spot foreign exchange rate falls to $0.52/TRY1 over the year.

6. Using the information in part 4, calculate the return on the FI’s loan portfolio, the average cost of funds, and the net interest margin for the FI if the pound spot foreign exchange rate rises to $1.70/£1 and the lira spot foreign exchange rate falls to $0.58/TRY1 over the year.

7. Suppose that instead of funding the $300 million investment in 8 percent British loans with CDs issued in the United Kingdom, the FI manager hedges the foreign exchange risk on the British loans by immediately selling its expected oneyear pound loan proceeds in the forward FX market. The current forward one-year exchange rate between dollars and pounds is $1.53/£1. Additionally, instead of funding the $200 million investment in 10 percent Turkish loans with CDs issued in the Turkey, the FI manager hedges the foreign exchange risk on the Turkish loans by immediately selling its expected one-year lira loan proceeds in the forward FX market. The current forward one-year exchange rate between dollars and Turkish lira is $0.5486/ TRY1. Calculate the return on the FI’s investment portfolio (including the hedge) and the net interest margin for the FI over the year.

Solution:

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