Question

The following rates exist: Current spot exchange rate: \$1.80/£ Annualized interest rate on 90-day dollar-denominated bonds:...

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)?

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