Question

An English institutional investor has invested in a portfolio of stocks in Russia. The annual inflation rate is 6 percent in Russia and 2.5 percent in the England.

Suppose that the annual return on the portfolio is 12 percent in Russian rubles, and the Russian ruble depreciated with respect to the pound by 5 percent. Also suppose that a Russian institutional investor also held a portfolio with the same composition. Compare the real returns for both investors, and discuss why they do or do not differ from one another.

Answer 1

Answer

1) First calculating real return for English institutional investor.

= There is a 12% return in Russian rubles which is notional return. To calculate Notional return for English investors we must incorporate currency exchange depreciation in return, as Russian rubles is weaker than a pound at year end. This means return for English investor will decline as now pound is able to buy more Russian Rubles, therefore, English institutional investor will receive less pound.

So notional return for English investor will be

= 1.12/1.05

= 1.06667

= 6.67%

Now to calculate real return we must incorporate inflation in notional return. This is done because as inflation increase purchasing power decreases, goods become costlier. Notional interest does not consider inflation, therefore, it is not actual return because as inflation goes up prices increase, which means even if you are earning notional return you will not be able to buy as many goods as you could have in start of the year with the same return.

= Real return = 1.0667/1.025 = 4.07%

Real return for Russian institutional investor

Know we know Notional Return in Russian rubles is 12%, Therefore we just need to incorporate inflation to calculate real return for Russian institutional investor.

= 1.12/1.06

= 5.66%

The real return of both the institutional investor differ from each other is because of 2 factors.

1) Depreciation in Russian Rubles compared to Pound.

2) The difference of Inflation rate in countries.

If there would have been no change in the exchange rate and inflation is the same for both countries, real return for both investors should be the same.