Exchange Rate Risk: A US financial institution borrowed $100 million for 1 year through deposits in the US. At the same time, it borrowed a sum equivalent to $100 million in GBP for 1 year from a lender in UK when the exchange rate was 1.4 USD per GBP. The interest rate that the financial institution has to pay on US deposits is 2% while the same to UK lender is 1%. The financial institution used $150 million to give out a 1-year loan to a US firm at an interest rate of 5%. The remaining $50 million, in GBP equivalent, went as a 1-year loan to a UK firm at an interest rate of 4% (the exchange rate is still 1.4 USD per GBP).

(a) What is the exchange rate risk that the US institution is facing? (b) What is the average spread on the balance sheet if the spot exchange rate appreciates to 1.2 USD per GBP an year from now? (c) What is the average spread on the balance sheet if the spot exchange rate depreciates to 1.6 USD per GBP an year from now? (d) Let us say that the financial institution wants to hedge the exchange rate risk on the balance sheet. In order to do that, the financial institution keeps the liability side the same but it gives two loans on the asset side. First 1-year loan to a US firm that pays 5% per year and the second 1-year loan to a UK firm that pays 4% per year. Both the loans amount to $100 million at current exchange rate. What is the new average spreads on the balance sheet if the spot exchange rate appreciates to 1.2 USD per GBP or depreciates to 1.6 USD per GBP an year from now?