Consider the following two strategies for moving pounds from a given moment to one year later: (i) buying a one-year UK bond and (ii) exchanging the pounds into euros, buying a one-year bond denominated in euros, and converting the proceeds from this bond one year later back into pounds. Assume that historically these two strategies have had the same yield on average. Furthermore, assume that the yield on a one-year UK bond bought today is 2 percent and the yield on a one-year bond denominated in euros bought today is 5 percent. Let V denote the expected appreciation (in percent) of the pound relative to the euro over the next year according to uncovered interest rate parity. Let W denote the expected appreciation (in percent) of the pound relative to the euro over the next year according to the empirical data. V equals how many percent? Is W larger than V, smaller than V, or equal to V?
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