Suppose that the current interest rates are equal to 5 percent p.a. in both Canada (the home country) and the uk, and the current and expected exchange rate are CAD/GBP 2. The Bank of England now...

Suppose that the current interest rates are equal to 5 percent p.a. in both Canada (the home country) and the uk, and the current and expected exchange rate are CAD/GBP 2. The Bank of England now increases its interest rate to 5.025 percent p.a. in an attempt to stem further rises in UK ination. It is quite possible that this increase in interest rates is interpreted by the market as a negative signal about the future state of the UK economy (the BoE wants to slow things down) or as insufficient to stop inflation. So the market may revise expectations about the CAD/GBP exchange rate from 2 to 1.95. Thus, the change in the interest rate is insufficient to match the drop in the expected exchange rate. Instead of appreciating, the current exchange rate drops to CAD/GBP 1:95 1:0525=10; 5 = 1:955: