Question

The following rates exist:

Current spot exchange rate: $1.80/£

Annualized interest rate on 90-day dollar-denominated bonds: 8% (2% for 90 days)

Annualized interest rate on 90-day pound-denominated bonds: 12% (3% for 90 days)

Financial investors expect the spot exchange rate to be $1.77/£ in 90 days.

Calculate the expected premium or discount on the pound

What would you expect the 90-day expected spot exchange rate to be under uncovered interest rate parity conditions using the approximate UIRP (i.e., the investor is indifferent between investing in London or New York)?

Answer 1

a) If the US investor invests in Dollar denominated bonds, he gets a return of 2% on them for 90 days

If US investors invest in Pound then their return in 90 days equals 1.77*3%/1.80 = 2.95%

So for US investor it is better to invest in pound

b) For UK investor he gets a return of 3% in UK

If he invests in US then he gets a return of 1.8*2%/1.77 = 2.03%

So he is better off investing in UK

C) There will be large scale inflows into UK which would lead to dollar depreciation and appreciation for Pound