Task 1. Would you be willing to invest the funds in this country without covering your position? Explain. It looks like investing in this country could be very profitable because the yield offered would be 14 percent (compared to only 9 percent in the US), but there are a few possible dangers in making an investment in a market that’s not stable yet. The country’s currency has become market-determined, so it’s volatile as it tries to find its equilibrium which means unstable market for now. Another problem is the probability of high inflation as the interest rate is much too high for a stable economy. High inflation rate is connected with the currency depreciation, which leads to prices increase. Furthermore, a risk of a large fluctuation in the value of the currency (40 percent above or below the expected value) exists. There is also the currency risk, which would occur due to unexpected changes in the exchange rate between the Dollar and the local currency. Hence the whole operation seems risky, some coverage should apply. Task 2. Suggest how you could attempt covered interest arbitrage. What is the expected return from using covered interest arbitrage? The currency risk needs to be covered to avoid exposure and make riskless profit from the forward premium. Covered Interest Arbitrage could mean exchanging dollars for the foreign currency at the spot rate now, investing the currency in the funds and then, after a year, selling this currency for the changed forward rate and get the dollars in return. 10 million USD, would exchange into the foreign currency at the spot rate ($.40) and obtain 25 million units of the foreign currency. At the end of the year, this amount will rise to 28.5 million units of the foreign currency (14% interest rate). This sum can be converted again into USD, but now the forward exchange rate ($.39). After this operation the amount equals 11,115,445 USD, which means that the return is ca 11,15%. Task 3. What risks are...
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