1．Paul Wilkes, a U.S. investor, is interested in investing in securities in the Caribbean country of Grenada. He is convinced that current market conditions make the securities of Grenada very attractive relative to those securities of other countries. Wilkes’ current portfolio is composed entirely of domestic securities, with an allocation of 60 percent equity and 40 percent fixed income. Wilkes has little experience in global investing, but has decided that the timing is right to invest at least 10 percent of his portfolio in foreign assets. Wilkes is particularly attracted to the high rate of return attainable in the Grenada market, but first needs to determine if the additional risk outweighs the return. 

After carefully developing his investment criteria and researching the financial markets of Grenada, Wilkes has narrowed his potential investments down to one choice. The secondary markets for equities issued in Grenada are more illiquid than Wilkes had previously thought. This lack of liquidity in the equities market leads Wilkes to determine that equities would be an inappropriate investment for his portfolio. However, bonds issued by the government of Grenada seem to have a history of good liquidity as well as steady returns, both of which are qualities Wilkes is seeking for his portfolio. Wilkes must now use various methods to determine expected returns for these bonds, given a one-year time horizon, expected changes in the U.S./Grenada exchange rates, and inflation rates. Wilkes also must consider the foreign currency risk premium of the issue, and decide if it is appropriate given the additional exposure. 

The currency of Grenada is the Eastern Caribbean Dollar (ECD). The current exchange rate is 2.50 USD/ECD. The ratio of the price levels of American goods to Grenadian goods is also 2.50. Inflation in the U.S. is expected to be 2 percent and 3 percent in Grenada. The end-of-year expected spot exchange rate is 2.75 USD/ECD. The one-year U.S. (risk free) interest rate is 4 percent, and in Grenada it is 8 percent. 

Also assume that these two currencies are the only ones that exist. The world portfolio risk premium is 6 percent. The security Wilkes is interested in is a government issue that has a world beta of 1.25 and currency exposure of 0.80.

What is the beginning of period real exchange rate and the end of period real rate, respectively?

A)   2.50; 2.55.

B)   2.50; 1.11.

C)   1.00; 1.11.

D)   6.25; 6.94.

2．Has there been a change in the real exchange rate?

A)   Yes, purchasing power has changed.

B)   No, inflation remained constant.

C)   Not enough information to determine.

D)   No, the inflation differential compensated for the change in the spot rate.

3．For this question, assume the real exchange rate is expected to be constant. What is the expected exchange rate?

A)   2.40.

B)   2.48.

C)   2.52.

D)   2.50.

4．For this question, assume the real exchange rate is expected to be constant. If the U.S. investor wants to buy a bond in Grenada, what would be the approximate expected return of this bond?

A)   8%.

B)   9%.

C)   6%.

D)   7%.

5．What is the foreign currency risk premium (SRP)?

A)   10.0%.

B)   6.0%.

C)   14.0%.

D)   -5.1%.

1．Paul Wilkes, a U.S. investor, is interested in investing in securities in the Caribbean country of Grenada. He is convinced that current market conditions make the securities of Grenada very attractive relative to those securities of other countries. Wilkes’ current portfolio is composed entirely of domestic securities, with an allocation of 60 percent equity and 40 percent fixed income. Wilkes has little experience in global investing, but has decided that the timing is right to invest at least 10 percent of his portfolio in foreign assets. Wilkes is particularly attracted to the high rate of return attainable in the Grenada market, but first needs to determine if the additional risk outweighs the return. 

After carefully developing his investment criteria and researching the financial markets of Grenada, Wilkes has narrowed his potential investments down to one choice. The secondary markets for equities issued in Grenada are more illiquid than Wilkes had previously thought. This lack of liquidity in the equities market leads Wilkes to determine that equities would be an inappropriate investment for his portfolio. However, bonds issued by the government of Grenada seem to have a history of good liquidity as well as steady returns, both of which are qualities Wilkes is seeking for his portfolio. Wilkes must now use various methods to determine expected returns for these bonds, given a one-year time horizon, expected changes in the U.S./Grenada exchange rates, and inflation rates. Wilkes also must consider the foreign currency risk premium of the issue, and decide if it is appropriate given the additional exposure. 

The currency of Grenada is the Eastern Caribbean Dollar (ECD). The current exchange rate is 2.50 USD/ECD. The ratio of the price levels of American goods to Grenadian goods is also 2.50. Inflation in the U.S. is expected to be 2 percent and 3 percent in Grenada. The end-of-year expected spot exchange rate is 2.75 USD/ECD. The one-year U.S. (risk free) interest rate is 4 percent, and in Grenada it is 8 percent. 

Also assume that these two currencies are the only ones that exist. The world portfolio risk premium is 6 percent. The security Wilkes is interested in is a government issue that has a world beta of 1.25 and currency exposure of 0.80.

What is the beginning of period real exchange rate and the end of period real rate, respectively?

A)   2.50; 2.55.

B)   2.50; 1.11.

C)   1.00; 1.11.

D)   6.25; 6.94.

The correct answer was C)

Beginning of period real exchange rate:
X₀ = S x P_F/P_D = (2.5USD/ECD)(1.0P_Grenada/2.50P_US) = 1.0 USD/ECD

End of period real exchange rate:
X₁ = (2.75 USD/ECD)(1.03P_Grenada/2.55P_US) = 1.11 USD/ECD

P_Grenada = 1 x 1.03 = 1.03
P_US = 2.50 x 1.02 = 2.55

2．Has there been a change in the real exchange rate?

A)   Yes, purchasing power has changed.

B)   No, inflation remained constant.

C)   Not enough information to determine.

D)   No, the inflation differential compensated for the change in the spot rate.

The correct answer was A)

The real exchange rate was 1.00 at the beginning of the period, and at the end it is 1.11.

3．For this question, assume the real exchange rate is expected to be constant. What is the expected exchange rate?

A)   2.40.

B)   2.48.

C)   2.52.

D)   2.50.

The correct answer was B)

If the real rate remains constant, the change in the exchange rate will be the inflation differential. Since the differential is 1 percent, we would expect to see the ECD depreciate by 1 percent against the dollar. Hence, the expected exchange rate is = 2.50USD/ECD / (1.01) = 2.475USD/ECD.

4．For this question, assume the real exchange rate is expected to be constant. If the U.S. investor wants to buy a bond in Grenada, what would be the approximate expected return of this bond?

A)   8%.

B)   9%.

C)   6%.

D)   7%.

The correct answer was D)

The return on the bond should be approximately equal to the foreign interest rate minus the depreciation of the foreign currency = 8% + (–1%) = 7%.

5．What is the foreign currency risk premium (SRP)?

A)   10.0%.

B)   6.0%.

C)   14.0%.

D)   -5.1%.

The correct answer was C)

SRP = (E(S₁) - S₀)/S₀ – (r_DC – r_FC)
The expected foreign currency appreciation is = (2.75 – 2.50) / (2.50) = 0.10.
The SRP is the expected foreign currency appreciation minus the interest rate differential: