Assume that instead of investing in Euro bonds at a fixed rate of 6.5 percent, the FI invests them in variable rates of LIBOR + 1.5 percent, reset every six months. The current LIBOR rate is 5 percent. Assume both interest and principal will be reinvested in six months. Assume the exchange rate remains at €1.75/$ at the end of the year. What should be the LIBOR rates in six months in order for the bank to earn a 1 percent spread?
A)5.25 percent.
B)5.48 percent.
C)5.76 percent.
D)5.86 percent.
E)5.94 percent.

Question

Quizplus · Accepted Answer

To earn a 1 percent spread, the FI needs to earn 7.5 percent annually (6.5 percent fixed rate + 1 percent spread). If the variable rate is LIBOR + 1.5 percent, then the effective rate in the first six months will be 6.5 percent (the fixed rate) and the effective rate in the second six months will depend on the LIBOR rate. Let x be the six-month LIBOR rate that equates to an annual effective rate of 7.5 percent:
(1 + x)^2 = (1 + 0.05)(1 + 0.015)^2(1 + 0.075)
Solving for x yields x = 0.0576, or 5.76 percent. Therefore, the LIBOR rate in six months needs to be 5.76 percent in order for the bank to earn a 1 percent spread.

Assume That Instead of Investing in Euro Bonds at a Fixed