Suppose you are an American investor. The interest rate on

a dollar deposit (????$) is 5% and on a British pound deposit (????₤) is 3%. Today’s exchange

rate (????$/₤ ) is $1.80/₤; and the expected exchange rate one year in the future (????^e

$/ ₤) is $1.85/₤.

Compare the rate of return from two deposits:

 

1. a)  Does UIP (uncovered interest rate parity) condition hold here?

2. b)  If not, given that interest rates in two countries remain the same, how much should

   British pound appreciate or depreciate against the US dollar to have UIP?

3. c)  Which deposit should you choose, given that you are rational and assume there is no

   frictions or restrictions across countries?

4. d)  Assume now you have the right to sign a forward exchange rate contract ($/₤) to lock

   the exchange rate in one year such that you are indifferent from US and British deposit, what will the forward exchange rate be on your contract in order to have CIP (covered interest rate parity)?