Behavioural finance

Consider the following two strategies for moving pounds from a given moment to one year later: (i) buying a one-year UK bond and (ii) exchanging the pounds into euros, buying a one-year bond denominated in euros, and converting the proceeds from this bond one year later back into pounds. Assume that the yield on a one-year UK bond bought today is 3 percent and the yield on a one-year bond denominated in euros bought today is 7 percent. Let X denote the expected appreciation (in percent) of the pound relative to the euro over the next year according to the simple version of uncovered interest rate parity. Let Y denote the expected appreciation (in percent) of the pound relative to the euro over the next year according to the empirical data.

a) X equals how many percent? [7 marks]

b) Is Y larger than X, smaller than X, or equal to X? [7 marks]

c) If X differs from Y, is this necessarily at odds with mainstream finance? If yes, why? If no, why not? [6 marks]