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!