Problem
Argentina pegged its peso to the U.S. dollar at one peso per USD from April 1991 to January 2002. In June 2000, the 3-month interest rates quoted by Argentine banks in Argentina were 6.71% for USD deposit and 7.33% for peso deposit.
Suppose the interest rate differential reflected some probability that the pegged exchange rate system would be abandoned and the peso is allowed to float. The market expects that the peso would depreciate by 10% to 1.10 peso per USD once it is allowed to float. What is the probability that the pegged exchange rate would break if uncovered interest rate parity holds?
By December 2001, confidence in the pegged exchange rate system further eroded and the interest differential soared, with 3-month interest rate for peso deposit at 20% and 3-month interest rate for USD deposit at 6.0% in Argentina. The market continues to expect that the peso would depreciate by 10% to 1.10 peso per USD once it is allowed to float. What is the probability that the pegged exchange rate would break if uncovered interest rate parity holds?