This exercise is about the \"carry trade, \" an operation in which investors bor

Question

This exercise is about the "carry trade, " an operation in which investors borrow in a low-interest- rate currency (called the "funding" currency) to invest in a high-interest-rate currency (the investment currency). The funding currency is the dollar and the investment currency is the peso. The authorities in charge of the peso want to maintain a fixed exchange rate of E=1 dollar per peso. However, there is a risk that the peso will be devalued (depreciated) and that the exchange rate will decrease to E=0.5 dollar per peso (a 50 percent depreciation) 23 Bond markets participants think that there is a certain probability p that the peso will be devalued in the future. If there is no devaluation the exchange rate will remains at E=1 dollar per peso. How does the expected exchange rate E^e depend on the probability p? (you should express E^e in terms of p.)

Explanation / Answer

Ee = p 0.5 + (1-p)*1

= 1 -0.5p

here p is probbaility of devaluation and   

1-p is the probbaility of no devaluation

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