Question

Anne, who is a Canadian saver, would like to invest $65,000 dollars (Canadian dollars to be precise). She is considering two options, buying a Canadian discount bond or a Russian discount bond, and Anne would like you compare returns on both options. The world risk-free rate is 0.25%. There is no risk premium on the Canadian discount bond, and the risk premium on the Russian discount bond is 5%. The current nominal Russian-Canadian exchange rate is ecan=56 Rubbles (Rubbles per Canadian dollar). Before the pay-out next period, you expect (and of course, Anne agrees with you), Rubbles will depreciate relative to Canadian dollar, efuture=60 Rubbles (again, Rubbles per Canadian dollar). Based on your forecast, what is the expected rate of return (% yield) on each investment. For simplicity, please assume zero transaction costs and no difference in taxes (zero taxes on both options).

Answer 1

If Anne invests in Canadian discount bond for a year,

She earns an interest of $ 65,000 * 0.25% = $ 162.5

Total expected Return on Canadian discount bond being 0.25%

If Anne invests in Russian discount bond for a year,

First she needs to convert Canadian Dollars into Russian Rubbles

so we get $ 65,000 * 56 Rubbles per Canadian dollar = 3,640,000 Rubbles

The Interest Rate Russian discount bond as per CAPM is,

Risk Free Rate + Risk Premium = 0.25% + 5 %= 5.25%

She earns an interest of 3,640,000 Rubbles * 5.25% = 191,100 Rubbles

Investment Totals with interest = 3,640,000 Rubbles + 191,100 Rubbles

= 3,831,100 Rubbles

Converting Rubbles into Canadian $ we get

3,831,100 Rubbles / 60 Rublles per Canadian $ = $ 63,851.67

Total Loss = $ 65,000 - $ 63,851.67 = $ 1,148.33

Total expected Return on Russian discount bond

being -1.767% (-1148.33/65000*100)

Conclusion :- Candian Discount Bond is a better Investment Choice