1.A British money financier is managing 10 million and wants to invest it in safe bonds either in France or United Kingdom for one year. The one-year interest rate on such assets is 0.63% in Britain and 0% in France. The one-year forward euro-pound exchange rate is 1.121 / (euros per pound). Assume that the covered interest parity condition (CIP) always holds and to ensure consistency, treat the UK as home country.

(a)Suppose the financier believes that the uncovered interest parity (IP) condition also holds and the foreign exchange market participants are acting based on correct expectations about future spot euro-pound exchange rate in the sense that their expectations predict the future rate without bias. Given these assumptions, what is the one-year expected spot euro-pound exchange rate prevailing in the market?Explain and show your work.[8]

Answer:

(b)Now suppose that the financier believes that while the uncovered interest parity (IP) condition also holds, the foreign exchange market participants have incorrect expectations about future spot euro-pound exchange rate. She believes that she has a better understanding of the economy and expects the future spot rate to be 1.2 /, on average. Assume that she is risk neutral in the foreign exchange market. Where should she invest the $10 million?Explain and show your work.[10]

Answer: