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Suppose currency traders expect that one year from now, £1 will be worth $1.50, and the one-year risk-free interest rate in the UK is 7% while the one-year risk-free rate in the US is 3%.
-If the one-year UK interest rate rises to 10% while the one-year US rate remains 3% and the one-year forward exchange rate remains £1 = $1.50,then the spot market value of £1 should become approximately

Question

Quizplus · Accepted Answer

The increase in the UK interest rate relative to the US interest rate makes holding pounds more attractive, leading to an appreciation of the pound in the spot market. Given the unchanged forward rate and the interest rate differential, the spot rate would adjust to reflect the new interest rate differential, leading to an appreciation of the pound beyond the forward rate expectation.

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