The current rates are: Spot exchange rate: $2.00/£. Annual interest rate on 60-day U.S. dollar-denominated bonds: 5%. Annual interest rate on 60-day pound-denominated bonds: 11%. Investors currently expect the spot exchange rate to be $1.98/pound in 60 days.
a. Show that uncovered interest parity holds (approximately) at these rates.
b. What is likely to be the effect on the spot exchange rate if the interest rate on 60-day pound-denominated bonds declines to 8 percent? If the dollar interest rate and the expected future spot rate are unchanged, and if uncovered interest parity is reestablished, what will the new current spot exchange rate be? Has the pound appreciated or depreciated?