Question: A British bank issues a $100 million, three-year Eurodollar CD at a fixed annual rate of 7 percent. The proceeds of the CD are lent to a British company for three years at a fixed rate of 9 percent. The spot exchange rate of pounds for U.S. dollars is £1.50/US$.
a. Is this expected to be a profitable transaction ex ante? What are the cash flows if exchange rates are unchanged over the next three years? What is the risk exposure of the bank's underlying cash position? How can the British bank reduce that risk exposure?
b. If the U.S. dollar is expected to appreciate against the pound to £1.65/$1,?£1.815/$1, and £2.00/$1 over the next three years, respectively, what will be the cash flows on this transaction?
c. If the British bank swaps U.S. dollar payments for British pound payments at the current spot exchange rate, what are the cash flows on the swap? What are the cash flows on the entire hedged position? Assume that the U.S. dollar appreciates at the same rates as in part (b).