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Suppose a local bank has the following balance sheet at t=0: Assets m=10 Asset y=90 Liabilities Debt d=30 Debt denominated in foreign currency d=60 Equity
Suppose a local bank has the following balance sheet at t=0: Assets m=10 Asset y=90 Liabilities Debt d=30 Debt denominated in foreign currency d=60 Equity e=10 mand dp are in foreign currency (US Dollar). Everything else is in local currency (Mexican peso). The bank keeps me units of foreign currency as assets. It gives loans of y=90 at t=0, which generate a return of R=1.3 per unit of loan at t=1, in local currency. That is, the loans y=90 generates 90x1.3=117 pesos at t=1. The bank is funded by equity e, local debt d (pesos) and foreign debt dF (US Dollar). Suppose, for simplicity, that the net interest on local and foreign debt is 0 (due to deposit insurance). That is, the bank owes local lenders d units of pesos and the foreign lenders de units of US dollars. At t=0, the exchange rate x is given as: x = 1 Dollar / 1 Peso = 1. The value of the exchange rate x at t=1 is random and has a Normal distribution with mean 1.3 and standard deviation 0.2. a) What is the probability that the bank fails at t=1? b) Suppose, due to credit risk, the loans generate a return of 1.1 per unit of loan at t=1 in local currency. What is the probability that the bank fails at t=1
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