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

a. The six-month forward rate on the Swedish krona 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?

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b. What forward rate will cause the spread to be only 1 per cent 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 per cent knowing that interest rate parity usually eliminates arbitrage opportunities created by differential rates?


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