The next questions refer to the following.
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%.
-Suppose American prices are twice as high as British prices,but there is no inflation occurring or expected in either country. In the short run,the US interest rate is 10% and the British interest rate is 5%. Then on the spot market,according to UIP,

Question

Quizplus · Accepted Answer

According to UIP (Uncovered Interest Rate Parity):
Expected spot rate = (1 + UK interest rate) / (1 + US interest rate) * Forward rate
Expected spot rate = (1 + 0.05) / (1 + 0.10) * 1.5
Expected spot rate = 0.95 * 1.5
Expected spot rate = 1.425
Since American prices are twice as high as British prices, this means that $1 buys £2. Thus, the expected spot rate is:
Expected spot rate = $1.425/£1 = £0.701
Therefore, the expected exchange rate is £1 = $1.425, which means £1 will appreciate to $1.91. Thus, the correct choice is C, £1 = $1.91 and the pound will appreciate to $2.00.

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