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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.
Question 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?
Question b. What forward rate will cause the spread to be only 1 percent per year?
Question c. Explain how forward and spot rates will both change in response to the increased spread?
Question 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?
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