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). Please note, to get full points, you
need to show all your steps.

Answer 1

We are given :

Initial amount for investment = $65,000

World risk free rate = 0.25%

Current exchange rate s.t : $1 = 56 rubbles

Expected exchange rate for next year s.t. $1 = 60 rubbles

Risk premium on canadian discount bond = 0%

Risk premium on russian discount bond = 5%

Return on canadian discount bond : 0.25% (As there is no risk premium on bond & no currency conversion is required as canadian dollars are getting investing in the canadian asset)

Return on russian discount bond:

Total money for investment = $65,000

Investment money in terms of russian rubbals = 65000 * 56 = 36,40,000 rubbles

Total value of investment after 1 year = 36,40,000* (1 + 0.05 +0.0025) = 38,31,100 rubbles (as 5% is the risk premium & 0.25% is the world risk free rate)

Converting the amount of asset in rubbles back into the canadian dollars = (38,31,100/ 60) = $ 63,851.67

Hence the expected return on russian discount bond = (63,851.67 - 65,000)/65,000 = -1.77%