Originally Posted by

**WoodyGD** Hi there, i'm reviewing a past paper for an upcoming test and I can't figure out how you get the answer for the following question:

1. (a) Suppose there is perfect capital mobility between the UK and the Eurozone and investors are risk-neutral. Over the next year, the pound sterling is expected to depreciate against the euro by 5% with a probability of 10%, to appreciate against the euro by 5% with a probability of 20%, and to retain its value against the euro with a probability of 70%. If the one-year interest rate on pound deposits is 5%, what should be the one-year interest rate on euro deposits?

I have applied the Uncovered Interest Parity Formula: R = R* + (Ee - E) / E

Where I believe:

R = 0.05

R* = ? (This is what we are trying to identify)

The answer provided by the examiner is: 5.5%

Please could someone give me some guidance as to how I should approach this question? Thanks for your help!