Consider a Dutch investor with 2,000 euros to place in a bank deposit in either the Europe or Great Britain. The one-year interest rate on bank deposits is 3% in Britain and 4% in Europe. The one-year forward euro-pound exchange rate is 1.6 euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions, using the exact equations for Covered Interest Rate Parity (CIP) and Uncovered Interest Rate Parity (UIP) as necessary.
a) If UIP holds, what is the expected euro-pound exchange rate one year ahead?
b) Based on your answer to a, what is the expected depreciation of the euro against the pound over one year?
c) Now assume that the Expected exchange rate does not change, but the interest rate in Europe dropped to 2%. What is the new euro-pound spot rate if the UIP holds.