Bank Trust is a US bank. The bank has been lending abroad and borrowing in the US markets, thus the bank is exposed to foreign exchange risk. In a recent transaction, the bank borrowed US$10 million via a one-year security at 5 per cent per annum nominal and funded a loan in Euros at 7.5 per cent. The spot rate at the time of this transaction was 1.19US$ = 1 (USD/Euro = 1.19).

(a) Immediately after the transaction closing, the bank received information indicated that the Euro would depreciate to US$1.18/ 1 by year end (i.e. 1.18US$ = 1). If the information is correct, what will be the realised spread on the loan? Assume adjustments in principal values are included in the spread. [3 marks]

(b) Suppose the bank had an opportunity to sell one-year forward Euros at US$1.191/1 (i.e. 1.191 US$ = 1). What would have been the spread on the loan if the bank had hedged forward its foreign exchange risk exposure? [2 marks]

(c) What does interest rate parity concept imply about the spread from investing in international markets calculated in part b? [2.5 marks]

(d) Suppose the bank decided to hedge foreign exchange risk using on-balance sheet technique. Without performing any calculations, explain the steps that would be followed to implement this technique. Explain how this technique reduces foreign exchange risk exposure. [2.5 marks]