Millon National Bank has 10 million British pounds (£) in one-year assets and £8 million in one-year liabilities.In addition, it has one-year liabilities of 4 million euros (€).Assets are earning 8 percent and both liabilities are being paid at a rate of 8 percent.All interest and principal will be paid at the end of the year.If the year-end spot exchange rate for the British pound is $1.50/£ and the liabilities pay 8 percent, what is the maximum that the € can appreciate and the bank still maintain a zero profit?

Question

Quizplus · Accepted Answer

Step 1: Calculate the interest income and expense for the bank in pounds:
Interest income = £10 million × 8% = £800,000
Interest expense = £8 million × 8% = £640,000

Step 2: Convert the euro liability to pounds using the year-end spot rate:
€4 million × $1.50/£ = £2.67 million

Step 3: Calculate the total interest expense for the bank in pounds:
Total interest expense = £640,000 + £2.67 million × 8% = £848,000

Step 4: Calculate the breakeven exchange rate where the bank earns zero profit:
Breakeven exchange rate = (£800,000 - £848,000) / €4 million = -€12/£

Step 5: Convert the breakeven exchange rate to dollars using the year-end spot rate:
-€12/£ × $1.50/£ = -$0.018/€
€1 = $1.50 - $0.018 = $1.482

Step 6: Calculate the maximum euro appreciation that the bank can tolerate and still maintain a zero profit:
€1 = $1.33 ($1.482/€)

Millon National Bank Has 10 Million British Pounds (£) in One-Year