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

To maintain zero profit, the bank needs to ensure that the interest received on its assets is equal to the interest paid on its liabilities, taking into account any exchange rate changes.

Assuming the bank has invested in assets denominated in euros, an appreciation in the euro would decrease the value of its assets when converted to dollars. To maintain the balance, the interest rate differential between the assets and liabilities must be adjusted by the exchange rate change.

Using the formula:

Interest received on assets in euros = Interest paid on liabilities in pounds x Spot exchange rate

Let X be the maximum appreciation of the euro in dollars that still results in zero profit.

Therefore:

0.08 (1 + X) = 0.08 x 1.5 / (1 + X)

Solving for X, we get:
X = 0.33

Therefore, the maximum appreciation of the euro in dollars that results in zero profit is €1.33/$ (choice B).

If the Year-End Spot Exchange Rate for the British Pound