Thread: International Finance Question

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!

R* is the current foreign interest rate
R is the current domestic interest rate

The formula I found on the web looking at different sources looks a bit different from the one you have listed

See this for reference Powered by Google Docs

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!

Hello,
Your problem relates to mathematical expectations. To solve this problem, you should be aware of probability and expected value.
If X is a random variable which can take anyone of the values X(1),X(2)………X(n)with respective probabilities P(1),P(2),P(3),…………P(n)then the mathematical expectation ( or expected value )of X usually denoted by E(X) is defined as
E(X)=P(1)X(1)+P(2)X(2)+P(3)X(3)+………………P(n)X(n)
Where each P(i) ≥0 and P(1) + P(2) +P(3)+…………P(n)=1
If you do some home work on probability and expected value, you will definitely get the answer provided by the examiner