1. In February 1994, Argentina's currency board was in place, and 1 peso was exchangeable into 1 dollar. The following interest rates were available:
U.S. LIBOR 90 days: 3.25% Peso 90-day deposits: 8.99%
Dollar interest rate in Argentina, 90-day deposits: 7.10%
The latter two rates were offered by Argentine banks. What risk does the difference between the 7.10% dollar interest and 3.25% LIBOR reflect? What risk does the difference between the rate on 90-day pesos and 90-day dollar deposits by Argentine banks reflect?
2. Consider the numbers in the previous question. Assume that if the peso were to depreciate, investors figure it will depreciate by 25%. Also, assume that if the Argentine bank were to default on its dollar obligations, it would pay nothing to investors. Compute the probability that the peso will devalue and the probability that there will be a default.