Question 1 [20] 1.1 What motivates financial institutions (FIS) to hedge foreign currency exposures? What are the limitations to hedging foreign currency exposures? (3) 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? (7) 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. (4) 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? (2) 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? (2)