Question 1

1.1 What motivates financial institutions (FIs) to hedge foreign currency exposures? What are the limitations to hedging foreign currency exposures?

1.2 What are the advantages and disadvantages of off-balance-sheet hedging in comparison to on-balance-sheet hedging? What are the two primary methods of hedging foreign exchange risk for an FI? What two conditions are necessary to achieve a perfect hedge through on-balance-sheet hedging?

1.3 A bank purchases a six-month, $1 million Eurodollar deposit at an annual interest rate of 6.5 percent. It invests the funds in a six-month Swedish krone AA-rated bond paying 7.5 percent per year. The current spot rate is $0.18/SK1.

a. The six-month forward rate on the Swedish krone is being quoted at $0.1810/SK1. What is the net spread earned on this investment if the bank covers its foreign exchange exposure using the forward market?

b. What forward rate will cause the spread to be only 1 percent per year?

c. Explain how forward and spot rates will both change in response to the increased spread?

d. Why will a bank still be able to earn a spread of 1 percent knowing that interest rate parity usually eliminates arbitrage opportunities created by differential rates?

Question 2

A $20 million loan outstanding to the Nigerian government is currently in arrears with City Bank. After extensive negotiations, City Bank agrees to reduce the interest rates from 10 percent to 6 percent and to lengthen the maturity of the loan to 10 years from the present 5 years remaining to maturity. The principal of the loan is to be paid at maturity. There will no grace period and the first interest payment is expected at the end of the year.

2.1 If the cost of funds is 5 percent for the bank, what is the present value of the loan prior to the rescheduling?

2.2 What is the present value of the rescheduled loan to the bank?

2.3 What is the concessionality of the rescheduled loan if the cost of funds remains at 5 percent and an up-front fee of 5 percent is charged?

2.4 What up-front fee should the bank charge to make the concessionality equal zero?

QUESTION 3

3.1 Discuss some of the advantages of an efficient technological base for a financial institution.

3.2 Using examples, discuss how technology can directly improve profitability in a financial institution.

3.3.Describe some of the automated retail payment products of financial institutions available today and the advantages these products offer the retail customer.

3.4 Explain the concept of interest rate parity?

3.5 What does this concept imply about the long-run profit opportunities from investing in international markets?