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Citibank wishes to invest in Yen loans at a rate of 10%
Citibank wishes to invest in Yen loans at a rate of 10%. The bank will fund the loans in the domestic CD market at a rate of 6.3%. This on-balance-sheet FX risk will be hedged in the spot market at some forward rate. The spot ratio yen is USD 0.60/Yen. What must be the forward exchange rate to eliminate the preference for the yen loans?
Expert Solution
Yen loans interest rate or Yen interest rate =10%
borrowing rate in CD or US interest rate = 6.3%
spot rate 1 yen = $0.60
Forward rate to eliminate preference for yen loans will be forward rate as per interest rate parity theory, which states whether we invest in domestic currency or in foreign currency, return will be at par
Forward rate of yen as per interest rate parity formula = spot rate*(1+dollar interest rate)/(1+yen interest rate)
=0.60*(1+10%)/(1+6.3%)
=0.6208842897
So forward rate should be $0.6209 per Yen to eliminate the preference for the yen loans
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