Sun Bank of Byron Bay has purchased a €16 million one-year loan that pays 12 per cent interest annually. The spot rate for euro is €1.60/$1. Sun Bank has funded this loan by accepting a UK pound- (GBP) denominated deposit for the equivalent amount and maturity at an annual rate of 10 per cent. The current spot rate of the UK pound is $1.60/£1.

a. What is the net interest income earned in dollars on this one-year transaction if the spot rates at the end of the year are €1.70/$1 and $1.85/£1?

b. What should be the GBP to AUD spot rate in order for the bank to earn a net interest margin of 4 per cent?

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c. Does your answer to part (b) imply that the dollar should appreciate or depreciate against the pound?

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