7. 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. [25 points total for Question 7]

1. What is the current euro-pound spot exchange rate? Explain and show your work.

Spot Rate = Forward Rate X (1+ Britain Int Rate)/ (1+France Int Rate)

Spot Rate = 121 X (1 + 0.63%)/(1+0%)

Spot Rate = 121.76

2. 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.

Answer:

3. 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.

Answer: