Problem
In 1991 Argentina pegged its peso to the U.S. dollar at one peso per USD. In June 2000, the 3-month interest rates quoted by Argentine banks were 6.71% in USD and 7.33% in peso. Suppose the difference reflected some probability that the currency board would be abandoned and the peso devalued, and investors think a 10% devaluation to peso 1.10 per USD is possible. What is the probability of this happening if uncovered interest rate parity holds?
In early 2001, confidence in the fixed exchange rate system further eroded and the interest differential soared to well over 10%. What is the possibility of a 10% devaluation if the 3-month interest rates are 20% in peso and 6.0% in USD? Note: All interest rates are quoted in annual rate.